CMP Associates Regulation Blog: Contraction of United States Real Private Fixed Investment with Swelling Undistributed Corporate Profits, Higher Growth of Deposits, Securities and Cash Assets than Loans in United States Commercial Banks and World Financial Turbulence and Economic Slowdown with Global Recession Risk: Part I

Contraction of United States Real Private Fixed Investment with Swelling Undistributed Corporate Profits, Higher Growth of Deposits, Securities and Cash Assets than Loans in United States Commercial Banks and World Financial Turbulence and Economic Slowdown with Global Recession Risk

Carlos M. Pelaez

Executive Summary

I Contraction of United States Real Private Fixed Investment and Swelling of Undistributed Corporate Profits

IA Contraction of United States Real Private Fixed Investment and Swelling of Undistributed Corporate Profits

IB Collapse of United States Dynamism of Income Growth and Employment Creation

II United States Commercial Banks Assets and Liabilities

IIA Transmission of Monetary Policy

IIB Functions of Banks

IIBC United States Commercial Banks Assets and Liabilities

III World Financial Turbulence

IIIA Financial Risks

IIIE Appendix Euro Zone Survival Risk

IIIF Appendix on Sovereign Bond Valuation

V World Economic Slowdown

VA United States

VB Japan

VC China

VD Euro Area

VE Germany

VF France

VG Italy

VH United Kingdom

VI Valuation of Risk Financial Assets

VII Economic Indicators

VIII Interest Rates

IX Conclusion

References

Appendixes

Appendix I The Great Inflation

IIIB Appendix on Safe Haven Currencies

IIIC Appendix on Fiscal Compact

IIID Appendix on European Central Bank Large Scale Lender of Last Resort

IIIG Appendix on Deficit Financing of Growth and the Debt Crisis

IIIGA Monetary Policy with Deficit Financing of Economic Growth

IIIGB Adjustment during the Debt Crisis of the 1980s

Executive Summary

ESI Contraction of United States Real Private Fixed Investment and Swelling Undistributed Corporate Profits. The United States economy has grown at the average yearly rate of 3 percent per year and 2 percent per year in per capita terms from 1870 to 2010, as measured by Lucas (2011May). An important characteristic of the economic cycle in the US has been rapid growth in the initial phase of expansion after recessions. In the cyclical expansions since 1950, US GDP has grown at the average rate of 6.2 percent, moving the economy back to long-term trend. Growth of GDP has been only 2.2 percent on average during the current cyclical expansion from IIIQ2009 to IIIQ2012 (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html). Weakness in the current cyclical expansion has occurred in growth, labor markets and wealth, as analyzed in IB Collapse of United States Dynamism of Income Growth and Employment Creation incorporating additional data on private investment. Inferior performance of the US economy and labor markets is the critical current issue of analysis and policy design. Table ESI-1 provides quarterly seasonally adjusted annual rates (SAAR) of growth of private fixed investment for the recessions of the 1980s and the current economic cycle. In the cyclical expansion beginning in IQ1983 (http://www.nber.org/cycles.html), real private fixed investment in the United States grew at the average annual rate of 15.3 percent in the first eight quarters from IQ1983 to IVQ1984. Growth rates fell to an average of 1.6 percent in the following eight quarters from IQ1985 to IVQ1986. There were only three quarters of contraction of private fixed investment from IQ1983 to IVQ1986. There is quite different behavior of private fixed investment in the thirteen quarters of cyclical expansion from IIIQ2009 to IIIQ2012. The average annual growth rate in the first eight quarters of expansion from IIIQ2009 to IIQ2011 was 2.5 percent, which is significantly lower than 15.3 percent in the first eight quarters of expansion from IQ1983 to IVQ1984. There is only strong growth of private fixed investment in the four quarters of expansion from IIIQ2011 to IQ2012 at the average annual rate of 11.9 percent. Growth has fallen from the SAAR of 15.5 percent in IIIQ2011 to 1.5 percent in IIIQ2012. Sudeep Reddy and Scott Thurm, writing on “Investment falls off a cliff,” on Nov 18, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324595904578123593211825394.html?mod=WSJPRO_hpp_LEFTTopStories) analyze the decline of private investment in the US and inform that a review by the Wall Street Journal of filing and conference calls finds that 40 of the largest publicly traded corporations in the US have announced intentions to reduce capital expenditures in 2012.

Table ESI-1, US, Quarterly Growth Rates of Real Private Fixed Investment, % Annual Equivalent SA

Q	1981	1982	1983	1984	2008	2009	2010
I	3.0	-11.6	9.0	13.1	-8.3	-30.2	-0.9
II	2.7	-13.3	16.4	17.5	-5.2	-18.5	14.5
III	0.0	-10.7	26.1	8.8	-12.3	-3.1	-1.0
IV	-1.4	0.6	25.6	7.4	-25.2	-6.0	7.6
				1985			2011
I				3.1			-1.3
II				5.1			12.4
III				-3.2			15.5
IV				7.8			10.0
				1986			2012
I				0.6			9.8
II				-1.0			4.5
III				-2.2			1.5
IV				2.7

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-1 of the US Bureau of Economic Analysis (BEA) provides seasonally-adjusted annual rates of growth of real private fixed investment from 1981 to 1986. Growth rates recovered sharply during the first eight quarters, which was essential in returning the economy to trend growth and eliminating unemployment and underemployment accumulated during the contractions.

Chart ESI-1, US, Real Private Fixed Investment, Seasonally-Adjusted Annual Rates Percent Change from Prior Quarter, 1981-1986

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Weak behavior of real private fixed investment from 2007 to 2012 is shown in Chart ESI-2. Growth rates of real private fixed investment were much lower during the initial phase of expansion in the current economic cycle and have entered sharp trend of decline.

Chart ESI-2, US, Real Private Fixed Investment, Seasonally-Adjusted Annual Rates Percent Change from Prior Quarter, 2007-2012

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Table I-2 provides real private fixed investment at seasonally-adjusted annual rates from IVQ2007 to IIIQ2012 or for the complete economic cycle. The first column provides the quarter, the second column percentage change relative to IVQ2007, the third quarter percentage change in the quarter relative to the prior quarter and the final column percentage change in a quarter relative to the same quarter a year earlier. In IQ1980 gross private domestic investment in the US was $778.3 billion of 2005 dollars, growing to $965.9 billion in IVQ1985 or 24.1 percent, as shown in Table IB-2 of IB Collapse of Dynamism of United States Income Growth and Employment Creation. Gross private domestic investment in the US decreased 10.5 percent from $2,123.6 billion of 2005 dollars in IVQ2007 to $1,900.9 billion in IIIQ2012. As shown in Table ESI-2, real private fixed investment fell 12.5 percent from $2111.5 billion of 2005 dollars in IVQ2007 to $1847.6 billion in IIIQ2012. Growth of real private investment in Table ESI-2 is mediocre for all but four quarters from IIQ2011 to IQ2012.

Table ESI-2, US, Real Private Fixed Investment and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions of Chained 2005 Dollars and ∆%

	Real PFI, Billions Chained 2005 Dollars	∆% Relative to IVQ2007	∆% Relative to Prior Quarter	∆% over Year Earlier
IVQ2007	2111.5	NA	-1.2	-1.0
IQ2008	2066.4	-2.1	-2.1	-2.9
IIQ2008	2039.1	-3.4	-1.3	-5.0
IIIQ2008	1973.5	-6.5	-3.2	-7.7
IV2008	1835.4	-13.1	-7.0	-13.1
IQ2009	1677.3	-20.6	-8.6	-18.8
IIQ2009	1593.7	-24.5	-5.0	-21.8
IIIQ2009	1581.2	-25.1	-0.8	-19.9
IVQ2009	1556.8	-26.3	-1.5	-15.2
IQ2010	1553.1	-26.4	-0.2	-7.4
IIQ2010	1606.5	-23.9	3.4	0.8
IIIQ2010	1602.7	-24.1	-0.2	1.4
IVQ2010	1632.3	-22.7	1.8	4.8
IQ2011	1627.0	-22.9	-0.3	4.8
IIQ2011	1675.4	-20.7	3.0	4.3
IIIQ2011	1736.8	-17.7	3.7	8.4
IVQ2011	1778.7	-15.8	2.4	9.0
IQ2012	1820.6	-13.8	2.4	11.9
IIQ2012	1840.6	-12.8	1.1	9.9
IIIQ2012	1847.6	-12.5	0.4	6.4

PFI: Private Fixed Investment

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-3 provides real private fixed investment in billions of chained 2005 dollars from IV2007 to IIIQ2012. Real private fixed investment has not recovered, stabilizing at a level in IIIQ2012 that is 12.5 percent below the level in IVQ2007.

Chart ESI-3, US, Real Private Fixed Investment, Billions of Chained 2005 Dollars, IVQ2007 to IIIQ2012

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-4 provides real gross private domestic investment in chained dollars of 2005 from 1980 to 1986. Real gross private domestic investment climbed 24.1 percent in IVQ1985 above the level on IQ1980.

Chart ESI-4, US, Real Gross Private Domestic Investment, Billions of Chained 2005 Dollars at Seasonally Adjusted Annual Rate, 1980-1986

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-5 provides real gross private domestic investment in the United States in billions of dollars of 2005 from 2006 to 2012. Gross private domestic investment reached a level in IIIQ2012 that was 10.5 percent lower than the level in IVQ2007.

Chart ESI-5, US, Real Gross Private Domestic Investment, Billions of Chained 2005 Dollars at Seasonally Adjusted Annual Rate, 2006-2012

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Table ESI-3 provides percentage shares in GDP of gross private domestic investment and its components in IIIQ2012, IQ2006 and IQ2000. The share of gross private domestic investment in GDP has fallen from 17.2 percent in IQ2000 and 17.8 percent in IQ2006 to 13.0 percent in IIIQ2012. There are declines in percentage shares in GDP of all components with sharp reduction of residential investment from 4.6 percent in IQ2000 and 6.2 percent in IQ2006 to 2.9 percent in IIIQ2012. The share of fixed investment in GDP fell from 17.2 percent in IQ2000 and 17.3 percent in IQ2006 to 12.7 percent in IIIQ2012.

Table ESI-3, Percentage Shares of Gross Private Domestic Investment and Components in Gross Domestic Product, % of GDP, IIIQ2012

	IIIIQ2012	IQ2006	IQ2000
Gross Private Domestic Investment	13.0	17.8	17.4
Fixed Investment	12.7	17.3	17.2
Nonresidential	10.2	11.1	12.6
Structures	2.9	3.0	3.1
Equipment and Software	7.3	8.1	9.5
Residential	2.5	6.2	4.6
Change in Private Inventories	0.3	0.5	0.2

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Broader perspective is provided in Chart ESI-6 with the percentage share of gross private domestic investment in GDP in annual data from 1929 to 2011. There was sharp drop during the current economic cycle with almost no recovery in contrast with sharp recovery after the recessions of the 1980s.

Chart ESI-6, US, Percentage Share of Gross Domestic Investment in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-7 provides percentage shares of private fixed investment in GDP with annual data from 1929 to 2011. The sharp contraction after the recessions of the 1980s was followed by sustained recovery while the sharp drop in the current economic cycle has not been recovered.

Chart ESI-7, US, Percentage Share of Private Fixed Investment in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-8 provides percentage shares in GDP of nonresidential investment from 1929 to 2011. There is again recovery from sharp contraction in the 1980s but inadequate recovery in the current economic cycle.

Chart ESI-8, US, Percentage Share of Nonresidential Investment in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-9 provides percentage shares of business equipment and software in GDP with annual data from 1929 to 2011. There is again inadequate recovery in the current economic cycle.

Chart ESI-9, US, Percentage Share of Business Equipment and Software in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-10 provides percentage shares of residential investment in GDP with annual data from 1929 to 2011. The salient characteristic of Chart I-10 is the vertical increase of the share of residential investment in GDP up to 2006 and subsequent collapse.

Chart ESI-10, US, Percentage Share of Residential Investment in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Finer detail is provided by the quarterly share of residential investment in GDP from 1979 to 2012 in Chart ESI-11. There was protracted growth of that share that accelerated sharply into 2006 followed with nearly vertical drop. The explanation of the sharp contraction of United States housing can probably be found in the origins of the financial crisis and global recession. Let V(T) represent the value of the firm’s equity at time T and B stand for the promised debt of the firm to bondholders and assume that corporate management, elected by equity owners, is acting on the interests of equity owners. Robert C. Merton (1974, 453) states:

“On the maturity date T, the firm must either pay the promised payment of B to the debtholders or else the current equity will be valueless. Clearly, if at time T, V(T) > B, the firm should pay the bondholders because the value of equity will be V(T) – B > 0 whereas if they do not, the value of equity would be zero. If V(T) ≤ B, then the firm will not make the payment and default the firm to the bondholders because otherwise the equity holders would have to pay in additional money and the (formal) value of equity prior to such payments would be (V(T)- B) < 0.”

Pelaez and Pelaez (The Global Recession Risk (2007), 208-9) apply this analysis to the US housing market in 2005-2006 concluding:

“The house market [in 2006] is probably operating with low historical levels of individual equity. There is an application of structural models [Duffie and Singleton 2003] to the individual decisions on whether or not to continue paying a mortgage. The costs of sale would include realtor and legal fees. There could be a point where the expected net sale value of the real estate may be just lower than the value of the mortgage. At that point, there would be an incentive to default. The default vulnerability of securitization is unknown.”

There are multiple important determinants of the interest rate: “aggregate wealth, the distribution of wealth among investors, expected rate of return on physical investment, taxes, government policy and inflation” (Ingersoll 1987, 405). Aggregate wealth is a major driver of interest rates (Ibid, 406). Unconventional monetary policy, with zero fed funds rates and flattening of long-term yields by quantitative easing, causes uncontrollable effects on risk taking that can have profound undesirable effects on financial stability. Excessively aggressive and exotic monetary policy is the main culprit and not the inadequacy of financial management and risk controls.

The net worth of the economy depends on interest rates. In theory, “income is generally defined as the amount a consumer unit could consume (or believe that it could) while maintaining its wealth intact” (Friedman 1957, 10). Income, Y, is a flow that is obtained by applying a rate of return, r, to a stock of wealth, W, or Y = rW (Ibid). According to a subsequent restatement: “The basic idea is simply that individuals live for many years and that therefore the appropriate constraint for consumption decisions is the long-run expected yield from wealth r*W. This yield was named permanent income: Y* = r*W” (Darby 1974, 229), where * denotes permanent. The simplified relation of income and wealth can be restated as:

W = Y/r (1)

Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞.

Lowering the interest rate near the zero bound in 2003-2004 caused the illusion of permanent increases in wealth or net worth in the balance sheets of borrowers and also of lending institutions, securitized banking and every financial institution and investor in the world. The discipline of calculating risks and returns was seriously impaired. The objective of monetary policy was to encourage borrowing, consumption and investment but the exaggerated stimulus resulted in a financial crisis of major proportions as the securitization that had worked for a long period was shocked with policy-induced excessive risk, imprudent credit, high leverage and low liquidity by the incentive to finance everything overnight at close to zero interest rates, from adjustable rate mortgages (ARMS) to asset-backed commercial paper of structured investment vehicles (SIV).

The consequences of inflating liquidity and net worth of borrowers were a global hunt for yields to protect own investments and money under management from the zero interest rates and unattractive long-term yields of Treasuries and other securities. Monetary policy distorted the calculations of risks and returns by households, business and government by providing central bank cheap money. Short-term zero interest rates encourage financing of everything with short-dated funds, explaining the SIVs created off-balance sheet to issue short-term commercial paper to purchase default-prone mortgages that were financed in overnight or short-dated sale and repurchase agreements (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). ARMS were created to lower monthly mortgage payments by benefitting from lower short-dated reference rates. Financial institutions economized in liquidity that was penalized with near zero interest rates. There was no perception of risk because the monetary authority guaranteed a minimum or floor price of all assets by maintaining low interest rates forever or equivalent to writing an illusory put option on wealth. Subprime mortgages were part of the put on wealth by an illusory put on house prices. The housing subsidy of $221 billion per year created the impression of ever increasing house prices. The suspension of auctions of 30-year Treasuries was designed to increase demand for mortgage-backed securities, lowering their yield, which was equivalent to lowering the costs of housing finance and refinancing. Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages and worked with leverage of 75:1 under Congress-provided charters and lax oversight. The combination of these policies resulted in high risks because of the put option on wealth by near zero interest rates, excessive leverage because of cheap rates, low liquidity because of the penalty in the form of low interest rates and unsound credit decisions because the put option on wealth by monetary policy created the illusion that nothing could ever go wrong, causing the credit/dollar crisis and global recession (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks, and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).

Chart ESI-11, US, Percentage Share of Residential Investment in Gross Domestic Product, Quarterly, 1979-2012

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Table ESI-4 provides the seasonally-adjusted annual rate of real GDP percentage change and contributions in percentage points in annual rate of gross domestic investment (GDI), real private fixed investment (PFI), nonresidential investment (NRES), business equipment and software (BES), residential investment (RES) and change in inventories (∆INV) for the cyclical expansions from IQ1983 to IVQ1985 and from IIIQ2009 to IIIQ2012. GDI provided strong percentage points contributions to GDP growth in the critical first year of expansion in 1983 and also in several quarters in 1984 and 1985 while it has been muted in the cyclical expansion from IIIQ2009 with contributions largely only from IQ2010 to IVQ2011, contributing 0.07 percentage points in IIIQ2012 and 0.07 percentage points in IIQ2012 in the fractured investment decision in the United States. Much of the strong performance of GDI in the cyclical expansion after IQ1983 originated in contributions by real private fixed investment (PFI). Nonresidential investment also contributed strongly to growth in the expansion of the 1980s but has been muted in the current expansion. The contribution of business equipment and software collapsed to nil in IIIQ2012 as business scales down investment. Residential investment (RES) was relatively strong in 1983 but was muted in following quarters and it only contributed to growth of GDP in the first three quarters of 2012.

Table ESI-4, US, Contributions to the Rate of Growth of Real GDP in Percentage Points

	GDP	GDI	PFI	NRES	BES	RES	∆INV
2012
I	2.0	0.78	1.18	0.74	0.39	0.43	-0.39
II	1.3	0.09	0.56	0.36	0.35	0.19	-0.46
III	2.0	0.07	0.20	-0.13	0.00	0.33	-0.12
2011
I	0.1	-0.68	-0.14	-0.11	0.72	-0.03	-0.54
II	2.5	1.40	1.39	1.30	0.53	0.09	0.01
III	1.3	0.68	1.75	1.71	1.20	0.03	-1.07
IV	4.1	3.72	1.19	0.93	0.62	0.26	2.53
2010
I	2.3	2.13	-0.10	0.20	0.90	-0.30	2.23
II	2.2	1.65	1.58	1.07	0.76	0.51	0.07
III	2.6	1.87	-0.10	0.70	0.76	-0.80	1.97
IV	2.4	-0.75	0.87	0.83	0.60	0.03	-1.61
2009
I	-5.3	-7.02	-4.73	-3.54	-2.16	-1.18	-2.29
II	-0.3	-3.52	-2.49	-1.86	-0.54	-0.63	-1.03
III	1.4	-0.14	-0.32	-0.73	0.25	0.40	0.19
IV	4.0	3.85	-0.69	-0.57	0.40	-0.12	4.55
1982
I	-6.4	-7.50	-2.04	-1.25	-0.47	-0.79	-5.47
II	2.2	-0.05	-2.40	-1.98	-1.19	-0.42	2.35
III	-1.5	-0.72	-1.87	-1.82	-0.57	-0.04	1.15
IV	0.3	-5.66	-0.18	-1.09	-0.60	0.92	-5.48
1983
I	5.1	2.20	1.26	-1.02	-0.18	2.28	0.94
II	9.3	5.87	2.36	0.52	-1.40	1.84	3.51
III	8.1	4.30	3.70	2.02	1.62	1.68	0.60
IV	8.5	6.84	3.76	2.98	2.50	0.77	3.09
1984
I	8.0	7.15	2.08	1.55	0.57	0.52	5.07
II	7.1	2.44	2.74	2.39	1.50	0.35	-0.30
III	3.9	1.67	1.45	1.62	1.05	-0.17	0.21
IV	3.3	-1.26	1.24	1.22	1.03	0.02	-2.50
1985
I	3.8	-2.38	0.57	0.62	-0.16	-0.06	-2.94
II	3.4	1.24	0.88	0.74	0.75	0.14	0.35
III	6.4	-0.68	-0.53	-0.75	-0.37	0.23	-0.16
IV	3.1	2.72	1.27	0.85	0.62	0.42	1.45

GDP: Gross Domestic Product; GDI: Gross Domestic Investment; PFI: Private Fixed Investment; NRES: Nonresidential; BES: Business Equipment and Software; RES: Residential; ∆INV: Change in Private Inventories.

GDI = PFI + ∆INV, may not add exactly because of errors of rounding.

GDP: seasonally-adjusted annual equivalent rate of growth in a quarter; components: percentage points at annual rate.

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Table ESI-5 provides value added of corporate business, dividends and corporate profits in billions of current dollars at seasonally-adjusted annual rates (SAAR) in IVQ2007 and IIQ2012 together with percentage changes. The last three rows of Table ESI-5 provide gross value added of nonfinancial corporate business, consumption of fixed capital and net value added in billions of chained 2005 dollars at SAARs. Deductions from gross value added of corporate profits down the rows of Table ESI-5 end with undistributed corporate profits. Profits after taxes with inventory valuation adjustment (IVA) and capital consumption adjustment (CCA) increased by 38.2 percent in nominal terms from IVQ2007 to IIQ2012 while net dividends fell 2.0 percent and undistributed corporate profits swelled 255.7 percent. The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Gross value added of nonfinancial corporate business adjusted for inflation increased 4.1 percent from IVQ2007 to IIQ2012, which is much lower than nominal increase of 11.2 percent in the same period for gross value added of total corporate business.

Table ESI-5, US, Value Added of Corporate Business, Corporate Profits and Dividends, IVQ2007-IIQ2012

	IVQ2007	IIQ2012	∆%
Current Billions of Dollars Seasonally Adjusted Annual Rates (SAAR)
Gross Value Added of Corporate Business	7,934.9	8,819.8	11.2
Consumption of Fixed Capital	959.2	1,104.3	15.1
Net Value Added	6,975.8	7,715.5	10.6
Compensation of Employees	4,888.5	5,248.6	7.4
Taxes on Production and Imports Less Subsidies	642.9	705.9	9.8
Net Operating Surplus	1444.3	1,761.0	21.9
Net Interest and Misc	144.8	175.4	21.1
Business Current Transfer Payment Net	72.1	100.3	39.1
Corporate Profits with IVA and CCA Adjustments	1,227.5	1,485.3	21.0
Taxes on Corporate Income	474.1	443.3	-6.5
Profits after Tax with IVA and CCA Adjustment	753.3	1,042.0	38.3
Net Dividends	635.3	622.3	-2.0
Undistributed Profits with IVA and CCA Adjustment	118.0	419.7	255.7
Billions of Chained USD 2005 SAAR
Gross Value Added of Nonfinancial Corporate Business	6,598.9	6,872.4	4.1
Consumption of Fixed Capital	788.1	840.7	6.7
Net Value Added	5,810.8	6,013.7	3.5

IVA: Inventory Valuation Adjustment; CCA: Capital Consumption Adjustment

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Table ESI-6 provides comparable United States value added of corporate business, corporate profits and dividends from IQ1980 to IVQ1985. There is significant difference both in nominal and inflation-adjusted data. Profits after tax with IVA and CCA increased 140.3 percent with dividends growing 112.7 percent and undistributed profits jumping 169.7 percent. There was much higher inflation in the 1980s than in the current cycle. For example, the consumer price index for all items not seasonally adjusted increased 34.9 percent between Mar 1980 and Dec 1985 but only 9.3 percent between Dec 2007 and Jun 2012 (http://www.bls.gov/cpi/data.htm). The comparison is still valid in terms of inflation-adjusted data: gross value added of nonfinancial corporate business adjusted for inflation increased 21.2 percent between IQ1980 and IVQ1985 but only 4.1 percent between IVQ2007 and IIQ2012 while net value added adjusted for inflation increased 20.6 percent between IQ1980 and IVQ1985 but only 3.5 percent between IVQ2007 and IIQ2012.

Table ESI-6, US, Value Added of Corporate Business, Corporate Profits and Dividends, IQ1980-IVQ1985

	IQ1980	IVQ1985	∆%
Current Billions of Dollars Seasonally Adjusted Annual Rates (SAAR)
Gross Value Added of Corporate Business	1,619.3	2,576.1	59.1
Consumption of Fixed Capital	169.9	278.9	64.2
Net Value Added	1,449.4	2,297.1	58.5
Compensation of Employees	1,090.6	1,667.0	52.9
Taxes on Production and Imports Less Subsidies	121.5	213.3	75.6
Net Operating Surplus	237.3	416.9	75.7
Net Interest and Misc	49.0	96.8	97.6
Business Current Transfer Payment Net	12.1	30.0	147.9
Corporate Profits with IVA and CCA Adjustments	176.3	290.0	64.5
Taxes on Corporate Income	97.0	99.7	2.8
Profits after Tax with IVA and CCA Adjustment	79.2	190.3	140.3
Net Dividends	40.9	87.0	112.7
Undistributed Profits with IVA and CCA Adjustment	38.3	103.3	169.7
Billions of Chained USD 2005 SAAR
Gross Value Added of Nonfinancial Corporate Business	2,642.8	3,203.9	21.2
Consumption of Fixed Capital	223.2	286.6	28.4
Net Value Added	2,419.6	2,917.3	20.6

IVA: Inventory Valuation Adjustment; CCA: Capital Consumption Adjustment

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-12 of the US Bureau of Economic Analysis provides quarterly corporate profits after tax and undistributed profits with IVA and CCA from 1979 to 2012. There is tightness between the series of quarterly corporate profits and undistributed profits in the 1980s with significant gap developing from 1988 and to the present with the closest approximation peaking in IVQ2005 and surrounding quarters. These gaps widened during all recessions including in 1991 and 2001 and recovered in expansions with exceptionally weak performance in the current expansion.

Chart ESI-12, US, Corporate Profits after Tax and Undistributed Profits with Inventory Valuation Adjustment and Capital Consumption Adjustment, Quarterly, 1979-2012

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Table ESI-7 provides price, costs and profit per unit of gross value added of nonfinancial domestic corporate income for IVQ2007 and IIQ2012 in the upper block and for IQ1980 and IVQ1985 in the lower block. Compensation of employees or labor costs per unit of gross value added of nonfinancial domestic corporate income hardly changed from 0.653 in IVQ2007 to 0.676 in IIQ2012 in a fractured labor market but increased from 0.386 in IQ1980 to 0.480 in IVQ1985 in a more vibrant labor market. Unit nonlabor costs increased mildly from 0.259 per unit of gross value added in IVQ2007 to 0.280 in IIQ2012 but increased from 0.127 in IQ1980 to 0.175 in IVQ1985 in an economy closer to full employment of resources. Profits after tax with IVA and CCA per unit of gross value added of nonfinancial domestic corporate income increased from 0.087 in IVQ2007 to 0.115 in IIQ2012 and from 0.025 in IQ1980 to 0.053 in IVQ1985.

Table ESI-7, US, Price, Costs and Profit per Unit of Gross Value Added of Nonfinancial Domestic Corporate Income

	IVQ2007	IIQ2012
Price per Unit of Real Gross Value Added of Nonfinancial Corporate Business	1.045	1.116
Compensation of Employees (Unit Labor Cost)	0.653	0.676
Unit Nonlabor Cost	0.259	0.280
Consumption of Fixed Capital	0.126	0.135
Taxes on Production and Imports less Subsidies plus Business Current Transfer Payments (net)	0.102	0.108
Net Interest and Misc. Payments	0.031	0.037
Corporate Profits with IVA and CCA Adjustment (Unit Profits from Current Production)	0.134	0.159
Taxes on Corporate Income	0.047	0.044
Profits after Tax with IVA and CCA Adjustment	0.087	0.115
	IQ1980	IVQ1985
Price per Unit of Real Gross Value Added of Nonfinancial Corporate Business	0.566	0.730
Compensation of Employees (Unit Labor Cost)	0.386	0.480
Unit Nonlabor Cost	0.127	0.175
Consumption of Fixed Capital	0.060	0.078
Taxes on Production and Imports less Subsidies plus Business Current Transfer Payments (net)	0.047	0.068
Net Interest and Misc. Payments	0.020	0.029
Corporate Profits with IVA and CCA Adjustment (Unit Profits from Current Production)	0.054	0.075
Taxes on Corporate Income	0.029	0.022
Profits after Tax with IVA and CCA Adjustment	0.025	0.053

IVA: Inventory Valuation Adjustment; CCA: Capital Consumption Adjustment

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart ESI-13 provides quarterly profits after tax with IVA and CCA per unit of gross value added of nonfinancial domestic corporate income from 1980 to 2012. In an environment of idle labor and other productive resources nonfinancial corporate income increased after tax profits with IVA and CCA per unit of gross value added at a faster pace in the weak economy from IVQ2007 to IIQ2012 than in the vibrant expansion of the cyclical contractions of the 1980s. Part of the profits was distributed as dividends and significant part was retained as undistributed profits in the current economic cycle with frustrated investment decision.

Chart ESI-13, US, Profits after Tax with Inventory Valuation Adjustment and Capital Consumption Adjustment per Unit of Gross Value Added of Nonfinancial Domestic Corporate Income, 1980-2012

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

ESII Global Financial and Economic Risk. The International Monetary Fund (IMF) provides an international safety net for prevention and resolution of international financial crises. The IMF’s Financial Sector Assessment Program (FSAP) provides analysis of the economic and financial sectors of countries (see Pelaez and Pelaez, International Financial Architecture (2005), 101-62, Globalization and the State, Vol. II (2008), 114-23). Relating economic and financial sectors is a challenging task both for theory and measurement. The IMF provides surveillance of the world economy with its Global Economic Outlook (WEO) (http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/text.pdf), of the world financial system with its Global Financial Stability Report (GFSR) (http://www.imf.org/external/pubs/ft/gfsr/2012/02/index.htm) and of fiscal affairs with the Fiscal Monitor (http://www.imf.org/external/pubs/ft/fm/2012/02/pdf/fm1202.pdf). There appears to be a moment of transition in global economic and financial variables that may prove of difficult analysis and measurement. It is useful to consider a summary of global economic and financial risks, which are analyzed in detail in the comments of this blog in Section VI Valuation of Risk Financial Assets, Table VI-4.

Economic risks include the following:

1. China’s Economic Growth. China is lowering its growth target to 7.5 percent per year. The growth rate of GDP of China in the third quarter of 2012 of 2.2 percent is equivalent to 9.1 percent per year and GDP increased 7.4 percent relative to the third quarter of 2011.

2. United States Economic Growth, Labor Markets and Budget/Debt Quagmire. The US is growing slowly with 28.1 million in job stress, fewer 10 million full-time jobs, high youth unemployment, historically-low hiring and declining real wages.

3. Economic Growth and Labor Markets in Advanced Economies. Advanced economies are growing slowly. There is still high unemployment in advanced economies.

4. World Inflation Waves. Inflation continues in repetitive waves globally (see Section I).

A list of financial uncertainties includes:

1. Euro Area Survival Risk. The resilience of the euro to fiscal and financial doubts on larger member countries is still an unknown risk.

2. Foreign Exchange Wars. Exchange rate struggles continue as zero interest rates in advanced economies induce devaluation of their currencies.

3. Valuation of Risk Financial Assets. Valuations of risk financial assets have reached extremely high levels in markets with lower volumes.

4. Duration Trap of the Zero Bound. The yield of the US 10-year Treasury rose from 2.031 percent on Mar 9, 2012, to 2.294 percent on Mar 16, 2012. Considering a 10-year Treasury with coupon of 2.625 percent and maturity in exactly 10 years, the price would fall from 105.3512 corresponding to yield of 2.031 percent to 102.9428 corresponding to yield of 2.294 percent, for loss in a week of 2.3 percent but far more in a position with leverage of 10:1. Min Zeng, writing on “Treasurys fall, ending brutal quarter,” published on Mar 30, 2012, in the Wall Street Journal (http://professional.wsj.com/article/SB10001424052702303816504577313400029412564.html?mod=WSJ_hps_sections_markets), informs that Treasury bonds maturing in more than 20 years lost 5.52 percent in the first quarter of 2012.

5. Credibility and Commitment of Central Bank Policy. There is a credibility issue of the commitment of monetary policy (Sargent and Silber 2012Mar20).

6. Carry Trades. Commodity prices driven by zero interest rates have resumed their increasing path with fluctuations caused by intermittent risk aversion.

It is in this context of economic and financial uncertainties that decisions on portfolio choices of risk financial assets must be made. There is a new carry trade that learned from the losses after the crisis of 2007 or learned from the crisis how to avoid losses. The sharp rise in valuations of risk financial assets shown in Table VI-1 in the text after the first policy round of near zero fed funds and quantitative easing by the equivalent of withdrawing supply with the suspension of the 30-year Treasury auction was on a smooth trend with relatively subdued fluctuations. The credit crisis and global recession have been followed by significant fluctuations originating in sovereign risk issues in Europe, doubts of continuing high growth and accelerating inflation in China now complicated by political developments, events such as in the Middle East and Japan and legislative restructuring, regulation, insufficient growth, falling real wages, depressed hiring and high job stress of unemployment and underemployment in the US now with realization of growth standstill. The “trend is your friend” motto of traders has been replaced with a “hit and realize profit” approach of managing positions to realize profits without sitting on positions. There is a trend of valuation of risk financial assets driven by the carry trade from zero interest rates with fluctuations provoked by events of risk aversion or the “sharp shifts in risk appetite” of Blanchard (2012WEOApr, XIII). Table ESII-1, which is updated for every comment of this blog, shows the deep contraction of valuations of risk financial assets after the Apr 2010 sovereign risk issues in the fourth column “∆% to Trough.” There was sharp recovery after around Jul 2010 in the last column “∆% Trough to 11/23/12,” which has been recently stalling or reversing amidst bouts of risk aversion. “Let’s twist again” monetary policy during the week of Sep 23 caused deep worldwide risk aversion and selloff of risk financial assets (http://cmpassocregulationblog.blogspot.com/2011/09/imf-view-of-world-economy-and-finance.html http://cmpassocregulationblog.blogspot.com/2011/09/collapse-of-household-income-and-wealth.html). Monetary policy was designed to increase risk appetite but instead suffocated risk exposures. There has been rollercoaster fluctuation in risk aversion and financial risk asset valuations: surge in the week of Dec 2, 2011, mixed performance of markets in the week of Dec 9, renewed risk aversion in the week of Dec 16, end-of-the-year relaxed risk aversion in thin markets in the weeks of Dec 23 and Dec 30, mixed sentiment in the weeks of Jan 6 and Jan 13 2012 and strength in the weeks of Jan 20, Jan 27 and Feb 3 followed by weakness in the week of Feb 10 but strength in the weeks of Feb 17 and 24 followed by uncertainty on financial counterparty risk in the weeks of Mar 2 and Mar 9. All financial values have fluctuated with events such as the surge in the week of Mar 16 on favorable news of Greece’s bailout even with new risk issues arising in the week of Mar 23 but renewed risk appetite in the week of Mar 30 because of the end of the quarter and the increase in the firewall of support of sovereign debts in the euro area. New risks developed in the week of Apr 6 with increase of yields of sovereign bonds of Spain and Italy, doubts on Fed policy and weak employment report. Asia and financial entities are experiencing their own risk environments. Financial markets were under stress in the week of Apr 13 because of the large exposure of Spanish banks to lending by the European Central Bank and the annual equivalent growth rate of China’s GDP of 7.4 percent in IQ2012 [(1.018)⁴], which was repeated in IIQ2012. There was strength again in the week of Apr 20 because of the enhanced IMF firewall and Spain placement of debt, continuing into the week of Apr 27. Risk aversion returned in the week of May 4 because of the expectation of elections in Europe and the new trend of deterioration of job creation in the US. Europe’s sovereign debt crisis and the fractured US job market continued to influence risk aversion in the week of May 11. Politics in Greece and banking issues in Spain were important factors of sharper risk aversion in the week of May 18. Risk aversion continued during the week of May 25 and exploded in the week of Jun 1. Expectations of stimulus by central banks caused valuation of risk financial assets in the week of Jun 8 and in the week of Jun 15. Expectations of major stimulus were frustrated by minor continuance of maturity extension policy in the week of Jun 22 together with doubts on the silent bank run in highly indebted euro area member countries. There was a major rally of valuations of risk financial assets in the week of Jun 29 with the announcement of new measures on bank resolutions by the European Council. New doubts surfaced in the week of Jul 6, 2012 on the implementation of the bank resolution mechanism and on the outlook for the world economy because of interest rate reductions by the European Central, Bank of England and People’s Bank of China. Risk appetite returned in the week of July 13 in relief that economic data suggests continuing high growth in China but fiscal and banking uncertainties in Spain spread to Italy in the selloff of July 20, 2012. Mario Draghi (2012Jul26), president of the European Central Bank, stated: “But there is another message I want to tell you.

Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” This statement caused return of risk appetite, driving upward valuations of risk financial assets worldwide. Buiter (2011Oct31) analyzes that the European Financial Stability Fund (EFSF) would need a “bigger bazooka” to bail out euro members in difficulties that could possibly be provided by the ECB. The dimensions of the problem may require more firepower than a bazooka perhaps that of the largest conventional bomb of all times of 44,000 pounds experimentally detonated only once by the US in 1948 (http://www.airpower.au.af.mil/airchronicles/aureview/1967/mar-apr/coker.html). Buiter (2012Oct15) finds that resolution of the euro crisis requires full banking union together with restructuring the sovereign debt of at least four and possibly total seven European countries. Risk appetite continued in the week of Aug 3, 2012, in expectation of purchases of sovereign bonds by the ECB. Growth of China’s exports by 1.0 percent in the 12 months ending in Jul 2012 released in the week of Aug 10, 2012, together with doubts on the purchases of bonds by the ECB injected a mild dose of risk aversion. There was optimism on the resolution of the European debt crisis on Aug 17, 2012. The week of Aug 24, 2012 had alternating shocks of risk aversion and risk appetite from the uncertainties of success of the Greek adjustment program, the coming decision of the Federal Constitutional Court of Germany on the European Stability Mechanism, disagreements between the Deutsche Bundesbank and the European Central Bank on purchase of sovereign bonds of highly indebted euro area member countries and the exchange of letters between Darrell E. Issa (2012Aug1), Chairman of the House Committee on Oversight and Government Reform, and Chairman Bernanke (2012Aug22) on monetary policy. Bernanke (2012JHAug31) and Draghi (2012Aug29) generated risk enthusiasm in the week of Aug 31, 2012. Risk appetite returned in the week of Sep 7, 2012, with the announcement of the bond-buying program of OMT (Outright Monetary Transactions) on Sep 6, 2012, by the European Central Bank (http://www.ecb.int/press/pr/date/2012/html/pr120906_1.en.html). Valuations of risk financial assets increased sharply after the statement of the FOMC on Sep 13, 2012 with open-ended quantitative easing and self-imposed single-mandate of jobs that would maintain easing monetary policy well after the economy returns to full potential. Risk aversion returned in the week of Sep 21, 2012 on doubts about the success of quantitative easing and weakness in flash purchasing managers’ indices. Risk aversion returned in the week of Sep 28, 2012, because of uncertainty on the consequences of a bailout of Spain and weakness of central banks in controlling financial turbulence but was followed by risk appetite in the week of Oct 5, aversion in the week of Oct 12 and mixed views in the week of Oct 19. Revenue declines for reporting companies caused decline of stocks in the week of Oct 26. Continuing risk aversion originates in the week of Nov 9 from the unresolved European debt crisis, world economic slowdown and low growth with fiscal challenges in the United States. Risk aversion continued in the week of Nov 16 with the unresolved European debt crisis, world economic slowdown and the unsustainable deficit/debt of the US threatening prosperity. Risk appetite returned in the Thanksgiving week with expectations of a deal for avoiding expenditure reductions and tax increases in the US in 2013. The highest valuations in column “∆% Trough to 11/23/12” are by US equities indexes: DJIA 34.3 percent and S&P 500 37.8 percent, driven by stronger earnings and economy in the US than in other advanced economies but with doubts on the relation of business revenue to the weakening economy and fractured job market. The DJIA reached 13,661.87 on Oct 5, 2012, which is the highest level in 52 weeks (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata). The carry trade from zero interest rates to leveraged positions in risk financial assets had proved strongest for commodity exposures but US equities have regained leadership. Before the current round of risk aversion, almost all assets in the column “∆% Trough to 11/23/12” had double digit gains relative to the trough around Jul 2, 2010 but now some valuations of equity indexes show varying behavior: China’s Shanghai Composite is 14.9 percent below the trough; Japan’s Nikkei Average is 6.2 percent above the trough; DJ Asia Pacific TSM is 9.1 percent above the trough; Dow Global is 13.1 percent above the trough; STOXX 50 of 50 blue-chip European equities (http://www.stoxx.com/indices/index_information.html?symbol=sx5E) is 10.4 percent above the trough; and NYSE Financial is 14.7 percent above the trough. DJ UBS Commodities is 16.2 percent above the trough. DAX index of German equities (http://www.bloomberg.com/quote/DAX:IND) is 28.9 percent above the trough. Japan’s Nikkei Average is 6.2 percent above the trough on Aug 31, 2010 and 17.8 percent below the peak on Apr 5, 2010. The Nikkei Average closed at 9366.80 on Fri Nov 23, 2012 (http://professional.wsj.com/mdc/public/page/marketsdata.html?mod=WSJ_PRO_hps_marketdata), which is 8.7 percent lower than 10,254.43 on Mar 11, 2011, on the date of the Tōhoku or Great East Japan Earthquake/tsunami. Global risk aversion erased the earlier gains of the Nikkei. The dollar depreciated by 8.9 percent relative to the euro and even higher before the new bout of sovereign risk issues in Europe. The column “∆% week to 11/23/12” in Table ESII-1 shows that there were increases of valuations of risk financial assets in the week of Nov 23, 2012 such as 4.2 percent for Dow Global, 4.0 percent for NYSE Financial, 3.6 percent for STOXX 50, 5.2 percent for DAX and 2.3 percent for DJ Asia Pacific TSM. Nikkei Average increased 3.8 percent in the week. DJ UBS Commodities increased 2.2 percent. China’s Shanghai Composite increased 0.6 percent in the week of Nov 23, 2012. The DJIA increased 3.3 percent and S&P 500 increased 3.6 percent. The USD depreciated 1.8 percent. There are still high uncertainties on European sovereign risks and banking soundness, US and world growth slowdown and China’s growth tradeoffs. Sovereign problems in the “periphery” of Europe and fears of slower growth in Asia and the US cause risk aversion with trading caution instead of more aggressive risk exposures. There is a fundamental change in Table ESII-1 from the relatively upward trend with oscillations since the sovereign risk event of Apr-Jul 2010. Performance is best assessed in the column “∆% Peak to 11/23/12” that provides the percentage change from the peak in Apr 2010 before the sovereign risk event to Nov 9, 2012. Most risk financial assets had gained not only relative to the trough as shown in column “∆% Trough to 11/23/12” but also relative to the peak in column “∆% Peak to 11/23/12.” There are now only three equity indexes above the peak in Table ESII-1: DJIA 16.1 percent, S&P 500 15.8 percent and DAX 15.4 percent. There are several indexes below the peak: NYSE Financial Index (http://www.nyse.com/about/listed/nykid.shtml) by 8.7 percent, Nikkei Average by 17.8 percent, Shanghai Composite by 35.9 percent, DJ Asia Pacific by 4.4 percent, STOXX 50 by 6.5 percent and Dow Global by 7.7 percent. DJ UBS Commodities Index is now 0.7 percent below the peak. The US dollar strengthened 14.2 percent relative to the peak. The factors of risk aversion have adversely affected the performance of risk financial assets. The performance relative to the peak in Apr 2010 is more important than the performance relative to the trough around early Jul 2010 because improvement could signal that conditions have returned to normal levels before European sovereign doubts in Apr 2010. Kate Linebaugh, writing on “Falling revenue dings stocks,” on Oct 20, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10000872396390444592704578066933466076070.html?mod=WSJPRO_hpp_LEFTTopStories), identifies a key financial vulnerability: falling revenues across markets for United States reporting companies. Global economic slowdown is reducing corporate sales and squeezing corporate strategies. Linebaugh quotes data from Thomson Reuters that 100 companies of the S&P 500 index have reported declining revenue only 1 percent higher in Jun-Sep 2012 relative to Jun-Sep 2011 but about 60 percent of the companies are reporting lower sales than expected by analysts with expectation that revenue for the S&P 500 will be lower in Jun-Sep 2012 for the entities represented in the index. Results of US companies are likely repeated worldwide. It may be quite painful to exit QE∞ or use of the balance sheet of the central together with zero interest rates forever. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

Where R_τ is expected revenue in the time horizon from τ =1 to T; C_τ denotes costs; and ρ is an appropriate rate of discount. In words, the value today of a stock or investment project is the net revenue, or revenue less costs, in the investment period from τ =1 to T discounted to the present by an appropriate rate of discount. In the current weak economy, revenues have been increasing more slowly than anticipated in investment plans. An increase in interest rates would affect discount rates used in calculations of present value, resulting in frustration of investment decisions. If V represents value of the stock or investment project, as ρ → ∞, meaning that interest rates increase without bound, then V → 0, or

declines. Equally, decline in expected revenue from the stock or project, R_τ, causes decline in valuation. An intriguing issue is the difference in performance of valuations of risk financial assets and economic growth and employment. Paul A. Samuelson (http://www.nobelprize.org/nobel_prizes/economics/laureates/1970/samuelson-bio.html) popularized the view of the elusive relation between stock markets and economic activity in an often-quoted phrase “the stock market has predicted nine of the last five recessions.” In the presence of zero interest rates forever, valuations of risk financial assets are likely to differ from the performance of the overall economy. The interrelations of financial and economic variables prove difficult to analyze and measure.

Table ESII-1, Stock Indexes, Commodities, Dollar and 10-Year Treasury

	Peak	Trough	∆% to Trough	∆% Peak to 11/23/ /12	∆% Week 11/23/12	∆% Trough to 11/23/ 12
DJIA	4/26/ 10	7/2/10	-13.6	16.1	3.3	34.3
S&P 500	4/23/ 10	7/20/ 10	-16.0	15.8	3.6	37.8
NYSE Finance	4/15/ 10	7/2/10	-20.3	-8.7	4.0	14.7
Dow Global	4/15/ 10	7/2/10	-18.4	-7.7	4.2	13.1
Asia Pacific	4/15/ 10	7/2/10	-12.5	-4.4	2.3	9.1
Japan Nikkei Aver.	4/05/ 10	8/31/ 10	-22.5	-17.8	3.8	6.2
China Shang.	4/15/ 10	7/02 /10	-24.7	-35.9	0.6	-14.9
STOXX 50	4/15/10	7/2/10	-15.3	-6.5	3.6	10.4
DAX	4/26/ 10	5/25/ 10	-10.5	15.4	5.2	28.9
Dollar Euro	11/25 2009	6/7 2010	21.2	14.2	-1.8	-8.9
DJ UBS Comm.	1/6/ 10	7/2/10	-14.5	-0.7	2.2	16.2
10-Year T Note	4/5/ 10	4/6/10	3.986	1.691

T: trough; Dollar: positive sign appreciation relative to euro (less dollars paid per euro), negative sign depreciation relative to euro (more dollars paid per euro)

Source: http://professional.wsj.com/mdc/page/marketsdata.html?mod=WSJ_hps_marketdata

I Contraction of United States Real Private Fixed Investment and Swelling Undistributed Corporate Profits. There are two subsections: IA Contraction of United States Real Private Fixed Investment and Swelling of Undistributed Corporate Profits and IB Collapse of United States Dynamism of Income Growth and Employment Creation.

IA Contraction of United States Real Private Fixed Investment and Swelling Undistributed Corporate Profits. The United States economy has grown at the average yearly rate of 3 percent per year and 2 percent per year in per capita terms from 1870 to 2010, as measured by Lucas (2011May). An important characteristic of the economic cycle in the US has been rapid growth in the initial phase of expansion after recessions. In the cyclical expansions since 1950, US GDP has grown at the average rate of 6.2 percent, moving the economy back to long-term trend. Growth of GDP has been only 2.2 percent on average during the current cyclical expansion from IIIQ2009 to IIIQ2012 (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html). Weakness in the current cyclical expansion has occurred in growth, labor markets and wealth, as analyzed in IB Collapse of United States Dynamism of Income Growth and Employment Creation incorporating additional data on private investment. Inferior performance of the US economy and labor markets is the critical current issue of analysis and policy design. Table I-1 provides quarterly seasonally adjusted annual rates (SAAR) of growth of private fixed investment for the recessions of the 1980s and the current economic cycle. In the cyclical expansion beginning in IQ1983 (http://www.nber.org/cycles.html), real private fixed investment in the United States grew at the average annual rate of 15.3 percent in the first eight quarters from IQ1983 to IVQ1984. Growth rates fell to an average of 1.6 percent in the following eight quarters from IQ1985 to IVQ1986. There were only three quarters of contraction of private fixed investment from IQ1983 to IVQ1986. There is quite different behavior of private fixed investment in the thirteen quarters of cyclical expansion from IIIQ2009 to IIIQ2012. The average annual growth rate in the first eight quarters of expansion from IIIQ2009 to IIQ2011 was 2.5 percent, which is significantly lower than 15.3 percent in the first eight quarters of expansion from IQ1983 to IVQ1984. There is only strong growth of private fixed investment in the four quarters of expansion from IIIQ2011 to IQ2012 at the average annual rate of 11.9 percent. Growth has fallen from the SAAR of 15.5 percent in IIIQ2011 to 1.5 percent in IIIQ2012. Sudeep Reddy and Scott Thurm, writing on “Investment falls off a cliff,” on Nov 18, 2012, published in the Wall Street Journal (http://professional.wsj.com/article/SB10001424127887324595904578123593211825394.html?mod=WSJPRO_hpp_LEFTTopStories) analyze the decline of private investment in the US and inform that a review by the Wall Street Journal of filing and conference calls finds that 40 of the largest publicly traded corporations in the US have announced intentions to reduce capital expenditures in 2012.

Table I-1, US, Quarterly Growth Rates of Real Private Fixed Investment, % Annual Equivalent SA

Q	1981	1982	1983	1984	2008	2009	2010
I	3.0	-11.6	9.0	13.1	-8.3	-30.2	-0.9
II	2.7	-13.3	16.4	17.5	-5.2	-18.5	14.5
III	0.0	-10.7	26.1	8.8	-12.3	-3.1	-1.0
IV	-1.4	0.6	25.6	7.4	-25.2	-6.0	7.6
				1985			2011
I				3.1			-1.3
II				5.1			12.4
III				-3.2			15.5
IV				7.8			10.0
				1986			2012
I				0.6			9.8
II				-1.0			4.5
III				-2.2			1.5
IV				2.7

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-1 of the US Bureau of Economic Analysis (BEA) provides seasonally-adjusted annual rates of growth of real private fixed investment from 1981 to 1986. Growth rates recovered sharply during the first eight quarters, which was essential in returning the economy to trend growth and eliminating unemployment and underemployment accumulated during the contractions.

Chart I-1, US, Real Private Fixed Investment, Seasonally-Adjusted Annual Rates Percent Change from Prior Quarter, 1981-1986

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Weak behavior of real private fixed investment from 2007 to 2012 is shown in Chart I-2. Growth rates of real private fixed investment were much lower during the initial phase of expansion in the current economic cycle and have entered sharp trend of decline.

Chart I-2, US, Real Private Fixed Investment, Seasonally-Adjusted Annual Rates Percent Change from Prior Quarter, 2007-2012

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Table I-2 provides real private fixed investment at seasonally-adjusted annual rates from IVQ2007 to IIIQ2012 or for the complete economic cycle. The first column provides the quarter, the second column percentage change relative to IVQ2007, the third quarter percentage change in the quarter relative to the prior quarter and the final column percentage change in a quarter relative to the same quarter a year earlier. In IQ1980 gross private domestic investment in the US was $778.3 billion of 2005 dollars, growing to $965.9 billion in IVQ1985 or 24.1 percent, as shown in Table IB-2 of IB Collapse of Dynamism of United States Income Growth and Employment Creation. Gross private domestic investment in the US decreased 10.5 percent from $2,123.6 billion of 2005 dollars in IVQ2007 to $1,900.9 billion in IIIQ2012. As shown in Table I-2, real private fixed investment fell 12.5 percent from $2111.5 billion of 2005 dollars in IVQ2007 to $1847.6 billion in IIIQ2012. Growth of real private investment in Table I-2 is mediocre for all but four quarters from IIQ2011 to IQ2012.

Table I-2, US, Real Private Fixed Investment and Percentage Change Relative to IVQ2007 and Prior Quarter, Billions of Chained 2005 Dollars and ∆%

	Real PFI, Billions Chained 2005 Dollars	∆% Relative to IVQ2007	∆% Relative to Prior Quarter	∆% over Year Earlier
IVQ2007	2111.5	NA	-1.2	-1.0
IQ2008	2066.4	-2.1	-2.1	-2.9
IIQ2008	2039.1	-3.4	-1.3	-5.0
IIIQ2008	1973.5	-6.5	-3.2	-7.7
IV2008	1835.4	-13.1	-7.0	-13.1
IQ2009	1677.3	-20.6	-8.6	-18.8
IIQ2009	1593.7	-24.5	-5.0	-21.8
IIIQ2009	1581.2	-25.1	-0.8	-19.9
IVQ2009	1556.8	-26.3	-1.5	-15.2
IQ2010	1553.1	-26.4	-0.2	-7.4
IIQ2010	1606.5	-23.9	3.4	0.8
IIIQ2010	1602.7	-24.1	-0.2	1.4
IVQ2010	1632.3	-22.7	1.8	4.8
IQ2011	1627.0	-22.9	-0.3	4.8
IIQ2011	1675.4	-20.7	3.0	4.3
IIIQ2011	1736.8	-17.7	3.7	8.4
IVQ2011	1778.7	-15.8	2.4	9.0
IQ2012	1820.6	-13.8	2.4	11.9
IIQ2012	1840.6	-12.8	1.1	9.9
IIIQ2012	1847.6	-12.5	0.4	6.4

PFI: Private Fixed Investment

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart I-3 provides real private fixed investment in billions of chained 2005 dollars from IV2007 to IIIQ2012. Real private fixed investment has not recovered, stabilizing at a level in IIIQ2012 that is 12.5 percent below the level in IVQ2007.

Chart I-3, US, Real Private Fixed Investment, Billions of Chained 2005 Dollars, IVQ2007 to IIIQ2012

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart I-4 provides real gross private domestic investment in chained dollars of 2005 from 1980 to 1986. Real gross private domestic investment climbed 24.1 percent in IVQ1985 above the level on IQ1980.

Chart I-4, US, Real Gross Private Domestic Investment, Billions of Chained 2005 Dollars at Seasonally Adjusted Annual Rate, 1980-1986

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-5 provides real gross private domestic investment in the United States in billions of dollars of 2005 from 2006 to 2012. Gross private domestic investment reached a level in IIIQ2012 that was 10.5 percent lower than the level in IVQ2007.

Chart I-5, US, Real Gross Private Domestic Investment, Billions of Chained 2005 Dollars at Seasonally Adjusted Annual Rate, 2006-2012

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Table I-3 provides percentage shares in GDP of gross private domestic investment and its components in IIIQ2012, IQ2006 and IQ2000. The share of gross private domestic investment in GDP has fallen from 17.2 percent in IQ2000 and 17.8 percent in IQ2006 to 13.0 percent in IIIQ2012. There are declines in percentage shares in GDP of all components with sharp reduction of residential investment from 4.6 percent in IQ2000 and 6.2 percent in IQ2006 to 2.9 percent in IIIQ2012. The share of fixed investment in GDP fell from 17.2 percent in IQ2000 and 17.3 percent in IQ2006 to 12.7 percent in IIIQ2012.

Table I-3, Percentage Shares of Gross Private Domestic Investment and Components in Gross Domestic Product, % of GDP, IIIQ2012

	IIIIQ2012	IQ2006	IQ2000
Gross Private Domestic Investment	13.0	17.8	17.4
Fixed Investment	12.7	17.3	17.2
Nonresidential	10.2	11.1	12.6
Structures	2.9	3.0	3.1
Equipment and Software	7.3	8.1	9.5
Residential	2.5	6.2	4.6
Change in Private Inventories	0.3	0.5	0.2

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Broader perspective is provided in Chart I-6 with the percentage share of gross private domestic investment in GDP in annual data from 1929 to 2011. There was sharp drop during the current economic cycle with almost no recovery in contrast with sharp recovery after the recessions of the 1980s.

Chart I-6, US, Percentage Share of Gross Domestic Investment in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart I-7 provides percentage shares of private fixed investment in GDP with annual data from 1929 to 2011. The sharp contraction after the recessions of the 1980s was followed by sustained recovery while the sharp drop in the current economic cycle has not been recovered.

Chart I-7, US, Percentage Share of Private Fixed Investment in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart I-8 provides percentage shares in GDP of nonresidential investment from 1929 to 2011. There is again recovery from sharp contraction in the 1980s but inadequate recovery in the current economic cycle.

Chart I-8, US, Percentage Share of Nonresidential Investment in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart I-9 provides percentage shares of business equipment and software in GDP with annual data from 1929 to 2011. There is again inadequate recovery in the current economic cycle.

Chart I-9, US, Percentage Share of Business Equipment and Software in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart I-10 provides percentage shares of residential investment in GDP with annual data from 1929 to 2011. The salient characteristic of Chart I-10 is the vertical increase of the share of residential investment in GDP up to 2006 and subsequent collapse.

Chart I-10, US, Percentage Share of Residential Investment in Gross Domestic Product, Annual, 1929-2011

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Finer detail is provided by the quarterly share of residential investment in GDP from 1979 to 2012 in Chart I-11. There was protracted growth of that share that accelerated sharply into 2006 followed with nearly vertical drop. The explanation of the sharp contraction of United States housing can probably be found in the origins of the financial crisis and global recession. Let V(T) represent the value of the firm’s equity at time T and B stand for the promised debt of the firm to bondholders and assume that corporate management, elected by equity owners, is acting on the interests of equity owners. Robert C. Merton (1974, 453) states:

Pelaez and Pelaez (The Global Recession Risk (2007), 208-9) apply this analysis to the US housing market in 2005-2006 concluding:

W = Y/r (1)

Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞.

Chart I-11, US, Percentage Share of Residential Investment in Gross Domestic Product, Quarterly, 1979-2012

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Table I-4 provides the seasonally-adjusted annual rate of real GDP percentage change and contributions in percentage points in annual rate of gross domestic investment (GDI), real private fixed investment (PFI), nonresidential investment (NRES), business equipment and software (BES), residential investment (RES) and change in inventories (∆INV) for the cyclical expansions from IQ1983 to IVQ1985 and from IIIQ2009 to IIIQ2012. GDI provided strong percentage points contributions to GDP growth in the critical first year of expansion in 1983 and also in several quarters in 1984 and 1985 while it has been muted in the cyclical expansion from IIIQ2009 with contributions largely only from IQ2010 to IVQ2011, contributing 0.07 percentage points in IIIQ2012 and 0.07 percentage points in IIQ2012 in the fractured investment decision in the United States. Much of the strong performance of GDI in the cyclical expansion after IQ1983 originated in contributions by real private fixed investment (PFI). Nonresidential investment also contributed strongly to growth in the expansion of the 1980s but has been muted in the current expansion. The contribution of business equipment and software collapsed to nil in IIIQ2012 as business scales down investment. Residential investment (RES) was relatively strong in 1983 but was muted in following quarters and it only contributed to growth of GDP in the first three quarters of 2012.

Table I-4, US, Contributions to the Rate of Growth of Real GDP in Percentage Points

	GDP	GDI	PFI	NRES	BES	RES	∆INV
2012
I	2.0	0.78	1.18	0.74	0.39	0.43	-0.39
II	1.3	0.09	0.56	0.36	0.35	0.19	-0.46
III	2.0	0.07	0.20	-0.13	0.00	0.33	-0.12
2011
I	0.1	-0.68	-0.14	-0.11	0.72	-0.03	-0.54
II	2.5	1.40	1.39	1.30	0.53	0.09	0.01
III	1.3	0.68	1.75	1.71	1.20	0.03	-1.07
IV	4.1	3.72	1.19	0.93	0.62	0.26	2.53
2010
I	2.3	2.13	-0.10	0.20	0.90	-0.30	2.23
II	2.2	1.65	1.58	1.07	0.76	0.51	0.07
III	2.6	1.87	-0.10	0.70	0.76	-0.80	1.97
IV	2.4	-0.75	0.87	0.83	0.60	0.03	-1.61
2009
I	-5.3	-7.02	-4.73	-3.54	-2.16	-1.18	-2.29
II	-0.3	-3.52	-2.49	-1.86	-0.54	-0.63	-1.03
III	1.4	-0.14	-0.32	-0.73	0.25	0.40	0.19
IV	4.0	3.85	-0.69	-0.57	0.40	-0.12	4.55
1982
I	-6.4	-7.50	-2.04	-1.25	-0.47	-0.79	-5.47
II	2.2	-0.05	-2.40	-1.98	-1.19	-0.42	2.35
III	-1.5	-0.72	-1.87	-1.82	-0.57	-0.04	1.15
IV	0.3	-5.66	-0.18	-1.09	-0.60	0.92	-5.48
1983
I	5.1	2.20	1.26	-1.02	-0.18	2.28	0.94
II	9.3	5.87	2.36	0.52	-1.40	1.84	3.51
III	8.1	4.30	3.70	2.02	1.62	1.68	0.60
IV	8.5	6.84	3.76	2.98	2.50	0.77	3.09
1984
I	8.0	7.15	2.08	1.55	0.57	0.52	5.07
II	7.1	2.44	2.74	2.39	1.50	0.35	-0.30
III	3.9	1.67	1.45	1.62	1.05	-0.17	0.21
IV	3.3	-1.26	1.24	1.22	1.03	0.02	-2.50
1985
I	3.8	-2.38	0.57	0.62	-0.16	-0.06	-2.94
II	3.4	1.24	0.88	0.74	0.75	0.14	0.35
III	6.4	-0.68	-0.53	-0.75	-0.37	0.23	-0.16
IV	3.1	2.72	1.27	0.85	0.62	0.42	1.45

GDI = PFI + ∆INV, may not add exactly because of errors of rounding.

GDP: seasonally-adjusted annual equivalent rate of growth in a quarter; components: percentage points at annual rate.

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Table I-5 provides value added of corporate business, dividends and corporate profits in billions of current dollars at seasonally-adjusted annual rates (SAAR) in IVQ2007 and IIQ2012 together with percentage changes. The last three rows of Table I-5 provide gross value added of nonfinancial corporate business, consumption of fixed capital and net value added in billions of chained 2005 dollars at SAARs. Deductions from gross value added of corporate profits down the rows of Table I-5 end with undistributed corporate profits. Profits after taxes with inventory valuation adjustment (IVA) and capital consumption adjustment (CCA) increased by 38.2 percent in nominal terms from IVQ2007 to IIQ2012 while net dividends fell 2.0 percent and undistributed corporate profits swelled 255.7 percent. The investment decision of United States corporations has been fractured in the current economic cycle in preference of cash. Gross value added of nonfinancial corporate business adjusted for inflation increased 4.1 percent from IVQ2007 to IIQ2012, which is much lower than nominal increase of 11.2 percent in the same period for gross value added of total corporate business.

Table I-5, US, Value Added of Corporate Business, Corporate Profits and Dividends, IVQ2007-IIQ2012

	IVQ2007	IIQ2012	∆%
Current Billions of Dollars Seasonally Adjusted Annual Rates (SAAR)
Gross Value Added of Corporate Business	7,934.9	8,819.8	11.2
Consumption of Fixed Capital	959.2	1,104.3	15.1
Net Value Added	6,975.8	7,715.5	10.6
Compensation of Employees	4,888.5	5,248.6	7.4
Taxes on Production and Imports Less Subsidies	642.9	705.9	9.8
Net Operating Surplus	1444.3	1,761.0	21.9
Net Interest and Misc	144.8	175.4	21.1
Business Current Transfer Payment Net	72.1	100.3	39.1
Corporate Profits with IVA and CCA Adjustments	1,227.5	1,485.3	21.0
Taxes on Corporate Income	474.1	443.3	-6.5
Profits after Tax with IVA and CCA Adjustment	753.3	1,042.0	38.3
Net Dividends	635.3	622.3	-2.0
Undistributed Profits with IVA and CCA Adjustment	118.0	419.7	255.7
Billions of Chained USD 2005 SAAR
Gross Value Added of Nonfinancial Corporate Business	6,598.9	6,872.4	4.1
Consumption of Fixed Capital	788.1	840.7	6.7
Net Value Added	5,810.8	6,013.7	3.5

IVA: Inventory Valuation Adjustment; CCA: Capital Consumption Adjustment

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Table I-6 provides comparable United States value added of corporate business, corporate profits and dividends from IQ1980 to IVQ1985. There is significant difference both in nominal and inflation-adjusted data. Profits after tax with IVA and CCA increased 140.3 percent with dividends growing 112.7 percent and undistributed profits jumping 169.7 percent. There was much higher inflation in the 1980s than in the current cycle. For example, the consumer price index for all items not seasonally adjusted increased 34.9 percent between Mar 1980 and Dec 1985 but only 9.3 percent between Dec 2007 and Jun 2012 (http://www.bls.gov/cpi/data.htm). The comparison is still valid in terms of inflation-adjusted data: gross value added of nonfinancial corporate business adjusted for inflation increased 21.2 percent between IQ1980 and IVQ1985 but only 4.1 percent between IVQ2007 and IIQ2012 while net value added adjusted for inflation increased 20.6 percent between IQ1980 and IVQ1985 but only 3.5 percent between IVQ2007 and IIQ2012.

Table I-6, US, Value Added of Corporate Business, Corporate Profits and Dividends, IQ1980-IVQ1985

	IQ1980	IVQ1985	∆%
Current Billions of Dollars Seasonally Adjusted Annual Rates (SAAR)
Gross Value Added of Corporate Business	1,619.3	2,576.1	59.1
Consumption of Fixed Capital	169.9	278.9	64.2
Net Value Added	1,449.4	2,297.1	58.5
Compensation of Employees	1,090.6	1,667.0	52.9
Taxes on Production and Imports Less Subsidies	121.5	213.3	75.6
Net Operating Surplus	237.3	416.9	75.7
Net Interest and Misc	49.0	96.8	97.6
Business Current Transfer Payment Net	12.1	30.0	147.9
Corporate Profits with IVA and CCA Adjustments	176.3	290.0	64.5
Taxes on Corporate Income	97.0	99.7	2.8
Profits after Tax with IVA and CCA Adjustment	79.2	190.3	140.3
Net Dividends	40.9	87.0	112.7
Undistributed Profits with IVA and CCA Adjustment	38.3	103.3	169.7
Billions of Chained USD 2005 SAAR
Gross Value Added of Nonfinancial Corporate Business	2,642.8	3,203.9	21.2
Consumption of Fixed Capital	223.2	286.6	28.4
Net Value Added	2,419.6	2,917.3	20.6

IVA: Inventory Valuation Adjustment; CCA: Capital Consumption Adjustment

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-12 of the US Bureau of Economic Analysis provides quarterly corporate profits after tax and undistributed profits with IVA and CCA from 1979 to 2012. There is tightness between the series of quarterly corporate profits and undistributed profits in the 1980s with significant gap developing from 1988 and to the present with the closest approximation peaking in IVQ2005 and surrounding quarters. These gaps widened during all recessions including in 1991 and 2001 and recovered in expansions with exceptionally weak performance in the current expansion.

Chart I-12, US, Corporate Profits after Tax and Undistributed Profits with Inventory Valuation Adjustment and Capital Consumption Adjustment, Quarterly, 1979-2012

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Table I-7 provides price, costs and profit per unit of gross value added of nonfinancial domestic corporate income for IVQ2007 and IIQ2012 in the upper block and for IQ1980 and IVQ1985 in the lower block. Compensation of employees or labor costs per unit of gross value added of nonfinancial domestic corporate income hardly changed from 0.653 in IVQ2007 to 0.676 in IIQ2012 in a fractured labor market but increased from 0.386 in IQ1980 to 0.480 in IVQ1985 in a more vibrant labor market. Unit nonlabor costs increased mildly from 0.259 per unit of gross value added in IVQ2007 to 0.280 in IIQ2012 but increased from 0.127 in IQ1980 to 0.175 in IVQ1985 in an economy closer to full employment of resources. Profits after tax with IVA and CCA per unit of gross value added of nonfinancial domestic corporate income increased from 0.087 in IVQ2007 to 0.115 in IIQ2012 and from 0.025 in IQ1980 to 0.053 in IVQ1985.

Table I-7, US, Price, Costs and Profit per Unit of Gross Value Added of Nonfinancial Domestic Corporate Income

	IVQ2007	IIQ2012
Price per Unit of Real Gross Value Added of Nonfinancial Corporate Business	1.045	1.116
Compensation of Employees (Unit Labor Cost)	0.653	0.676
Unit Nonlabor Cost	0.259	0.280
Consumption of Fixed Capital	0.126	0.135
Taxes on Production and Imports less Subsidies plus Business Current Transfer Payments (net)	0.102	0.108
Net Interest and Misc. Payments	0.031	0.037
Corporate Profits with IVA and CCA Adjustment (Unit Profits from Current Production)	0.134	0.159
Taxes on Corporate Income	0.047	0.044
Profits after Tax with IVA and CCA Adjustment	0.087	0.115
	IQ1980	IVQ1985
Price per Unit of Real Gross Value Added of Nonfinancial Corporate Business	0.566	0.730
Compensation of Employees (Unit Labor Cost)	0.386	0.480
Unit Nonlabor Cost	0.127	0.175
Consumption of Fixed Capital	0.060	0.078
Taxes on Production and Imports less Subsidies plus Business Current Transfer Payments (net)	0.047	0.068
Net Interest and Misc. Payments	0.020	0.029
Corporate Profits with IVA and CCA Adjustment (Unit Profits from Current Production)	0.054	0.075
Taxes on Corporate Income	0.029	0.022
Profits after Tax with IVA and CCA Adjustment	0.025	0.053

IVA: Inventory Valuation Adjustment; CCA: Capital Consumption Adjustment

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

Chart I-13 provides quarterly profits after tax with IVA and CCA per unit of gross value added of nonfinancial domestic corporate income from 1980 to 2012. In an environment of idle labor and other productive resources nonfinancial corporate income increased after tax profits with IVA and CCA per unit of gross value added at a faster pace in the weak economy from IVQ2007 to IIQ2012 than in the vibrant expansion of the cyclical contractions of the 1980s. Part of the profits was distributed as dividends and significant part was retained as undistributed profits in the current economic cycle with frustrated investment decision.

Chart I-13, US, Profits after Tax with Inventory Valuation Adjustment and Capital Consumption Adjustment per Unit of Gross Value Added of Nonfinancial Domestic Corporate Income, 1980-2012

Source: US Bureau of Economic Analysis

http://www.bea.gov/iTable/index_nipa.cfm

IB Collapse of United States Dynamism of Income Growth and Employment Creation. There are four major approaches to the analysis of the depth of the financial crisis and global recession from IVQ2007 (Dec) to IIQ2009 (Jun) and the subpar recovery from IIIQ2009 (Jul) to the present IIIQ2012: (1) deeper contraction and slower recovery in recessions with financial crises; (2) counterfactual of avoiding deeper contraction by fiscal and monetary policies; (3) counterfactual that the financial crises and global recession would have been avoided had economic policies been different; and (4) evidence that growth rates are higher after deeper recessions with financial crises. A counterfactual consists of theory and measurements of what would have occurred otherwise if economic policies or institutional arrangements had been different. This task is quite difficult because economic data are observed with all effects as they actually occurred while the counterfactual attempts to evaluate how data would differ had policies and institutional arrangements been different (see Pelaez and Pelaez, Globalization and the State, Vol. I (2008b), 125, 136). Counterfactual data are unobserved and must be calculated using theory and measurement methods. The measurement of costs and benefits of projects or applied welfare economics (Harberger 1971, 1997) specifies and attempts to measure projects such as what would be economic welfare with or without a bridge or whether markets would be more or less competitive in the absence of antitrust and regulation laws (Winston 2006). Counterfactuals were used in the “new economic history” of the United States to measure the economy with or without railroads (Fishlow 1965, Fogel 1964) and also in analyzing slavery (Fogel and Engerman 1974). A critical counterfactual in economic history is how Britain surged ahead of France (North and Weingast 1989). These four approaches are discussed below in turn followed with comparison of the two recessions of the 1980s from IQ1980 (Jan) to IIIQ1980 (Jul) and from IIIQ1981 (Jul) to IVQ1982 (Nov) as dated by the National Bureau of Economic Research (NBER http://www.nber.org/cycles.html). These comparisons are not idle exercises, defining the interpretation of history and even possibly critical policies and institutional arrangements. There is active debate on these issues (Bordo 2012Oct 21 http://www.bloomberg.com/news/2012-10-21/why-this-u-s-recovery-is-weaker.html Reinhart and Rogoff, 2012Oct14 http://www.economics.harvard.edu/faculty/rogoff/files/Is_US_Different_RR_3.pdf Taylor 2012Oct 25 http://www.johnbtaylorsblog.blogspot.co.uk/2012/10/an-unusually-weak-recovery-as-usually.html, Wolf 2012Oct23 http://www.ft.com/intl/cms/s/0/791fc13a-1c57-11e2-a63b-00144feabdc0.html#axzz2AotsUk1q).

(1) Lower Growth Rates in Recessions with Financial Crises. A monumental effort of data gathering, calculation and analysis by Professors Carmen M. Reinhart and Kenneth Rogoff at Harvard University is highly relevant to banking crises, financial crash, debt crises and economic growth (Reinhart 2010CB; Reinhart and Rogoff 2011AF, 2011Jul14, 2011EJ, 2011CEPR, 2010FCDC, 2010GTD, 2009TD, 2009AFC, 2008TDPV; see also Reinhart and Reinhart 2011Feb, 2010AF and Reinhart and Sbrancia 2011). See http://cmpassocregulationblog.blogspot.com/2011/07/debt-and-financial-risk-aversion-and.html. The dataset of Reinhart and Rogoff (2010GTD, 1) is quite unique in breadth of countries and over time periods:

“Our results incorporate data on 44 countries spanning about 200 years. Taken together, the data incorporate over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate and monetary arrangements and historic circumstances. We also employ more recent data on external debt, including debt owed by government and by private entities.”

Reinhart and Rogoff (2010GTD, 2011CEPR) classify the dataset of 2317 observations into 20 advanced economies and 24 emerging market economies. In each of the advanced and emerging categories, the data for countries is divided into buckets according to the ratio of gross central government debt to GDP: below 30, 30 to 60, 60 to 90 and higher than 90 (Reinhart and Rogoff 2010GTD, Table 1, 4). Median and average yearly percentage growth rates of GDP are calculated for each of the buckets for advanced economies. There does not appear to be any relation for debt/GDP ratios below 90. The highest growth rates are for debt/GDP ratios below 30: 3.7 percent for the average and 3.9 for the median. Growth is significantly lower for debt/GDP ratios above 90: 1.7 for the average and 1.9 percent for the median. GDP growth rates for the intermediate buckets are in a range around 3 percent: the highest 3.4 percent average is for the bucket 60 to 90 and 3.1 percent median for 30 to 60. There is even sharper contrast for the United States: 4.0 percent growth for debt/GDP ratio below 30; 3.4 percent growth for debt/GDP ratio of 30 to 60; 3.3 percent growth for debt/GDP ratio of 60 to 90; and minus 1.8 percent, contraction, of GDP for debt/GDP ratio above 90.

For the five countries with systemic financial crises—Iceland, Ireland, UK, Spain and the US—real average debt levels have increased by 75 percent between 2007 and 2009 (Reinhart and Rogoff 2010GTD, Figure 1). The cumulative increase in public debt in the three years after systemic banking crisis in a group of episodes after World War II is 86 percent (Reinhart and Rogoff 2011CEPR, Figure 2, 10).

An important concept is “this time is different syndrome,” which “is rooted in the firmly-held belief that financial crises are something that happens to other people in other countries at other times; crises do not happen here and now to us” (Reinhart and Rogoff 2010FCDC, 9). There is both an arrogance and ignorance in “this time is different” syndrome, as explained by Reinhart and Rogoff (2010FCDC, 34):

“The ignorance, of course, stems from the belief that financial crises happen to other people at other time in other places. Outside a small number of experts, few people fully appreciate the universality of financial crises. The arrogance is of those who believe they have figured out how to do things better and smarter so that the boom can long continue without a crisis.”

There is sober warning by Reinhart and Rogoff (2011CEPR, 42) on the basis of the momentous effort of their scholarly data gathering, calculation and analysis:

“Despite considerable deleveraging by the private financial sector, total debt remains near its historic high in 2008. Total public sector debt during the first quarter of 2010 is 117 percent of GDP. It has only been higher during a one-year sting at 119 percent in 1945. Perhaps soaring US debt levels will not prove to be a drag on growth in the decades to come. However, if history is any guide, that is a risky proposition and over-reliance on US exceptionalism may only be one more example of the “This Time is Different” syndrome.”

As both sides of the Atlantic economy maneuver around defaults the experience on debt and growth deserves significant emphasis in research and policy. The world economy is slowing with high levels of unemployment in advanced economies. Countries do not grow themselves out of unsustainable debts but rather through de facto defaults by means of financial repression and in some cases through inflation. The conclusion is that this time is not different.

Professor Alan M. Taylor (2012) at the University of Virginia analyzes own and collaborative research on 140 years of history with data from 14 advanced economies in the effort to elucidate experience anticipating, during and after financial crises. The conclusion is (Allan M. Taylor 2012, 8):

“Recessions might be painful, but they tend to be even more painful when combined with financial crises or (worse) global crises, and we already know that post-2008 experience will not overturn this conclusion. The impact on credit is also very strong: financial crises lead to strong setbacks in the rate of growth of loans as compared to what happens in normal recessions, and this effect is strong for global crises. Finally, inflation generally falls in recessions, but the downdraft is stronger in financial crisis times.”

Alan M. Taylor (2012) also finds that advanced economies entered the global recession with the largest financial sector in history. There was doubling after 1980 of the ratio of loans to GDP and tripling of the size of bank balance sheets. In contrast, in the period from 1950 to 1970 there was high investment, savings and growth in advanced economies with firm regulation of finance and controls of foreign capital flows.

(2) Counterfactual of the Global Recession. There is a difficult decision on when to withdraw the fiscal stimulus that could have adverse consequences on current growth and employment analyzed by Krugman (2011Jun18). CBO (2011JunLTBO, Chapter 2) considers the timing of withdrawal as well as the equally tough problems that result from not taking prompt action to prevent a possible debt crisis in the future. Krugman (2011Jun18) refers to Eggertsson and Krugman (2010) on the possible contractive effects of debt. The world does not become poorer as a result of debt because an individual’s asset is another’s liability. Past levels of credit may become unacceptable by credit tightening, such as during a financial crisis. Debtors are forced into deleveraging, which results in expenditure reduction, but there may not be compensatory effects by creditors who may not be in need of increasing expenditures. The economy could be pushed toward the lower bound of zero interest rates, or liquidity trap, remaining in that threshold of deflation and high unemployment.

Analysis of debt can lead to the solution of the timing of when to cease stimulus by fiscal spending (Krugman 2011Jun18). Excessive debt caused the financial crisis and global recession and it is difficult to understand how more debt can recover the economy. Krugman (2011Jun18) argues that the level of debt is not important because one individual’s asset is another individual’s liability. The distribution of debt is important when economic agents with high debt levels are encountering different constraints than economic agents with low debt levels. The opportunity for recovery may exist in borrowing by some agents that can adjust the adverse effects of past excessive borrowing by other agents. As Krugman (2011Jun18, 20) states:

“Suppose, in particular, that the government can borrow for a while, using the borrowed money to buy useful things like infrastructure. The true social cost of these things will be very low, because the spending will be putting resources that would otherwise be unemployed to work. And government spending will also make it easier for highly indebted players to pay down their debt; if the spending is sufficiently sustained, it can bring the debtors to the point where they’re no longer so severely balance-sheet constrained, and further deficit spending is no longer required to achieve full employment. Yes, private debt will in part have been replaced by public debt – but the point is that debt will have been shifted away from severely balance-sheet-constrained players, so that the economy’s problems will have been reduced even if the overall level of debt hasn’t fallen. The bottom line, then, is that the plausible-sounding argument that debt can’t cure debt is just wrong. On the contrary, it can – and the alternative is a prolonged period of economic weakness that actually makes the debt problem harder to resolve.”

Besides operational issues, the consideration of this argument would require specifying and measuring two types of gains and losses from this policy: (1) the benefits in terms of growth and employment currently; and (2) the costs of postponing the adjustment such as in the exercise by CBO (2011JunLTO, 28-31) in Table 11. It may be easier to analyze the costs and benefits than actual measurement.

An analytical and empirical approach is followed by Blinder and Zandi (2010), using the Moody’s Analytics model of the US economy with four different scenarios: (1) baseline with all policies used; (2) counterfactual including all fiscal stimulus policies but excluding financial stimulus policies; (3) counterfactual including all financial stimulus policies but excluding fiscal stimulus; and (4) a scenario excluding all policies. The scenario excluding all policies is an important reference or the counterfactual of what would have happened if the government had been entirely inactive. A salient feature of the work by Blinder and Zandi (2010) is the consideration of both fiscal and financial policies. There was probably more activity with financial policies than with fiscal policies. Financial policies included the Fed balance sheet, 11 facilities of direct credit to illiquid segments of financial markets, interest rate policy, the Financial Stability Plan including stress tests of banks, the Troubled Asset Relief Program (TARP) and others (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009b), 157-67; Regulation of Banks and Finance (2009a), 224-7).

Blinder and Zandi (2010, 4) find that:

“In the scenario that excludes all the extraordinary policies, the downturn continues into 2011. Real GDP falls a stunning 7.4% in 2009 and another 3.7% in 2010 (see Table 3). The peak-to-trough decline in GDP is therefore close to 12%, compared to an actual decline of about 4%. By the time employment hits bottom, some 16.6 million jobs are lost in this scenario—about twice as many as actually were lost. The unemployment rate peaks at 16.5%, and although not determined in this analysis, it would not be surprising if the underemployment rate approached one-fourth of the labor force. The federal budget deficit surges to over $2 trillion in fiscal year 2010, $2.6 trillion in fiscal year 2011, and $2.25 trillion in FY 2012. Remember, this is with no policy response. With outright deflation in prices and wages in 2009-2011, this dark scenario constitutes a 1930s-like depression.”

The conclusion by Blinder and Zandi (2010) is that if the US had not taken massive fiscal and financial measures the economy could have suffered far more during a prolonged period. There are still a multitude of questions that cloud understanding of the impact of the recession and what would have happened without massive policy impulses. Some effects are quite difficult to measure. An important argument by Blinder and Zandi (2010) is that this evaluation of counterfactuals is relevant to the need of stimulus if economic conditions worsened again.

(3) Counterfactual of Policies Causing the Financial Crisis and Global Recession. The counterfactual of avoidance of deeper and more prolonged contraction by fiscal and monetary policies is not the critical issue. As Professor John B. Taylor (2012Oct25) argues the critically important counterfactual is that the financial crisis and global recessions would have not occurred in the first place if different economic policies had been followed. The counterfactual intends to verify that a combination of housing policies and discretionary monetary policies instead of rules (Taylor 1993) caused, deepened and prolonged the financial crisis (Taylor 2007, 2008Nov, 2009, 2012FP, 2012Mar27, 2012Mar28, 2012JMCB; see http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html) and that the experience resembles that of the Great Inflation of the 1960s and 1970s with stop-and-go growth/inflation that coined the term stagflation (http://cmpassocregulationblog.blogspot.com/2012/06/rules-versus-discretionary-authorities.html http://cmpassocregulationblog.blogspot.com/2011/05/slowing-growth-global-inflation-great.html http://cmpassocregulationblog.blogspot.com/2011/04/new-economics-of-rose-garden-turned.html http://cmpassocregulationblog.blogspot.com/2011/03/is-there-second-act-of-us-great.html and Appendix I).

The explanation of the sharp contraction of United States housing can probably be found in the origins of the financial crisis and global recession. Let V(T) represent the value of the firm’s equity at time T and B stand for the promised debt of the firm to bondholders and assume that corporate management, elected by equity owners, is acting on the interests of equity owners. Robert C. Merton (1974, 453) states:

Pelaez and Pelaez (The Global Recession Risk (2007), 208-9) apply this analysis to the US housing market in 2005-2006 concluding:

W = Y/r (1)

Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞.

There are significant elements of the theory of bank financial fragility of Diamond and Dybvig (1983) and Diamond and Rajan (2000, 2001a, 2001b) that help to explain the financial fragility of banks during the credit/dollar crisis (see also Diamond 2007). The theory of Diamond and Dybvig (1983) as exposed by Diamond (2007) is that banks funding with demand deposits have a mismatch of liquidity (see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 58-66). A run occurs when too many depositors attempt to withdraw cash at the same time. All that is needed is an expectation of failure of the bank. Three important functions of banks are providing evaluation, monitoring and liquidity transformation. Banks invest in human capital to evaluate projects of borrowers in deciding if they merit credit. The evaluation function reduces adverse selection or financing projects with low present value. Banks also provide important monitoring services of following the implementation of projects, avoiding moral hazard that funds be used for, say, real estate speculation instead of the original project of factory construction. The transformation function of banks involves both assets and liabilities of bank balance sheets. Banks convert an illiquid asset or loan for a project with cash flows in the distant future into a liquid liability in the form of demand deposits that can be withdrawn immediately.

In the theory of banking of Diamond and Rajan (2000, 2001a, 2001b), the bank creates liquidity by tying human assets to capital. The collection of skills of the relationship banker converts an illiquid project of an entrepreneur into liquid demand deposits that are immediately available for withdrawal. The deposit/capital structure is fragile because of the threat of bank runs. In these days of online banking, the run on Washington Mutual was through withdrawals online. A bank run can be triggered by the decline of the value of bank assets below the value of demand deposits.

Pelaez and Pelaez (Regulation of Banks and Finance 2009b, 60, 64-5) find immediate application of the theories of banking of Diamond, Dybvig and Rajan to the credit/dollar crisis after 2007. It is a credit crisis because the main issue was the deterioration of the credit portfolios of securitized banks as a result of default of subprime mortgages. It is a dollar crisis because of the weakening dollar resulting from relatively low interest rate policies of the US. It caused systemic effects that converted into a global recession not only because of the huge weight of the US economy in the world economy but also because the credit crisis transferred to the UK and Europe. Management skills or human capital of banks are illustrated by financial engineering of complex products. The increasing importance of human relative to inanimate capital (Rajan and Zingales 2000) is revolutionizing the theory of the firm (Zingales 2000) and corporate governance (Rajan and Zingales 2001). Finance is one of the most important examples of this transformation. Profits were derived from the charter in the original banking institution. Pricing and structuring financial instruments was revolutionized with option pricing formulas developed by Black and Scholes (1973) and Merton (1973, 1974, 1998) that permitted the development of complex products with fair pricing. The successful financial company must attract and retain finance professionals who have invested in human capital, which is a sunk cost to them and not of the institution where they work.

The complex financial products created for securitized banking with high investments in human capital are based on houses, which are as illiquid as the projects of entrepreneurs in the theory of banking. The liquidity fragility of the securitized bank is equivalent to that of the commercial bank in the theory of banking (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65). Banks created off-balance sheet structured investment vehicles (SIV) that issued commercial paper receiving AAA rating because of letters of liquidity guarantee by the banks. The commercial paper was converted into liquidity by its use as collateral in SRPs at the lowest rates and minimal haircuts because of the AAA rating of the guarantor bank. In the theory of banking, default can be triggered when the value of assets is perceived as lower than the value of the deposits. Commercial paper issued by SIVs, securitized mortgages and derivatives all obtained SRP liquidity on the basis of illiquid home mortgage loans at the bottom of the pyramid. The run on the securitized bank had a clear origin (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 65):

“The increasing default of mortgages resulted in an increase in counterparty risk. Banks were hit by the liquidity demands of their counterparties. The liquidity shock extended to many segments of the financial markets—interbank loans, asset-backed commercial paper (ABCP), high-yield bonds and many others—when counterparties preferred lower returns of highly liquid safe havens, such as Treasury securities, than the risk of having to sell the collateral in SRPs at deep discounts or holding an illiquid asset. The price of an illiquid asset is near zero.”

Gorton and Metrick (2010H, 507) provide a revealing quote to the work in 1908 of Edwin R. A. Seligman, professor of political economy at Columbia University, founding member of the American Economic Association and one of its presidents and successful advocate of progressive income taxation. The intention of the quote is to bring forth the important argument that financial crises are explained in terms of “confidence” but as Professor Seligman states in reference to historical banking crises in the US the important task is to explain what caused the lack of confidence. It is instructive to repeat the more extended quote of Seligman (1908, xi) on the explanations of banking crises:

“The current explanations may be divided into two categories. Of these the first includes what might be termed the superficial theories. Thus it is commonly stated that the outbreak of a crisis is due to lack of confidence,--as if the lack of confidence was not in itself the very thing which needs to be explained. Of still slighter value is the attempt to associate a crisis with some particular governmental policy, or with some action of a country’s executive. Such puerile interpretations have commonly been confined to countries like the United States, where the political passions of democracy have had the fullest way. Thus the crisis of 1893 was ascribed by the Republicans to the impending Democratic tariff of 1894; and the crisis of 1907 has by some been termed the ‘[Theodore] Roosevelt panic,” utterly oblivious of the fact that from the time of President Jackson, who was held responsible for the troubles of 1837, every successive crisis had had its presidential scapegoat, and has been followed by a political revulsion. Opposed to these popular, but wholly unfounded interpretations, is the second class of explanations, which seek to burrow beneath the surface and to discover the more occult and fundamental causes of the periodicity of crises.”

Scholars ignore superficial explanations in the effort to seek good and truth. The problem of economic analysis of the credit/dollar crisis is the lack of a structural model with which to attempt empirical determination of causes (Gorton and Metrick 2010SB). There would still be doubts even with a well-specified structural model because samples of economic events do not typically permit separating causes and effects. There is also confusion is separating the why of the crisis and how it started and propagated, all of which are extremely important.

In true heritage of the principles of Seligman (1908), Gorton (2009EFM) discovers a prime causal driver of the credit/dollar crisis. The objective of subprime and Alt-A mortgages was to facilitate loans to populations with modest means so that they could acquire a home. These borrowers would not receive credit because of (1) lack of funds for down payments; (2) low credit rating and information; (3) lack of information on income; and (4) errors or lack of other information. Subprime mortgage “engineering” was based on the belief that both lender and borrower could benefit from increases in house prices over the short run. The initial mortgage would be refinanced in two or three years depending on the increase of the price of the house. According to Gorton (2009EFM, 13, 16):

“The outstanding amounts of Subprime and Alt-A [mortgages] combined amounted to about one quarter of the $6 trillion mortgage market in 2004-2007Q1. Over the period 2000-2007, the outstanding amount of agency mortgages doubled, but subprime grew 800%! Issuance in 2005 and 2006 of Subprime and Alt-A mortgages was almost 30% of the mortgage market. Since 2000 the Subprime and Alt-A segments of the market grew at the expense of the Agency (i.e., the government sponsored entities of Fannie Mae and Freddie Mac) share, which fell from almost 80% (by outstanding or issuance) to about half by issuance and 67% by outstanding amount. The lender’s option to rollover the mortgage after an initial period is implicit in the subprime mortgage. The key design features of a subprime mortgage are: (1) it is short term, making refinancing important; (2) there is a step-up mortgage rate that applies at the end of the first period, creating a strong incentive to refinance; and (3) there is a prepayment penalty, creating an incentive not to refinance early.”

The prime objective of successive administrations in the US during the past 20 years and actually since the times of Roosevelt in the 1930s has been to provide “affordable” financing for the “American dream” of home ownership. The US housing finance system is mixed with public, public/private and purely private entities. The Federal Home Loan Bank (FHLB) system was established by Congress in 1932 that also created the Federal Housing Administration in 1934 with the objective of insuring homes against default. In 1938, the government created the Federal National Mortgage Association, or Fannie Mae, to foster a market for FHA-insured mortgages. Government-insured mortgages were transferred from Fannie Mae to the Government National Mortgage Association, or Ginnie Mae, to permit Fannie Mae to become a publicly-owned company. Securitization of mortgages began in 1970 with the government charter to the Federal Home Loan Mortgage Corporation, or Freddie Mac, with the objective of bundling mortgages created by thrift institutions that would be marketed as bonds with guarantees by Freddie Mac (see Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 42-8). In the third quarter of 2008, total mortgages in the US were $12,057 billion of which 43.5 percent, or $5423 billion, were retained or guaranteed by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 45). In 1990, Fannie Mae and Freddie Mac had a share of only 25.4 percent of total mortgages in the US. Mortgages in the US increased from $6922 billion in 2002 to $12,088 billion in 2007, or by 74.6 percent, while the retained or guaranteed portfolio of Fannie and Freddie rose from $3180 billion in 2002 to $4934 billion in 2007, or by 55.2 percent.

According to Pinto (2008) in testimony to Congress:

“There are approximately 25 million subprime and Alt-A loans outstanding, with an unpaid principal amount of over $4.5 trillion, about half of them held or guaranteed by Fannie and Freddie. Their high risk activities were allowed to operate at 75:1 leverage ratio. While they may deny it, there can be no doubt that Fannie and Freddie now own or guarantee $1.6 trillion in subprime, Alt-A and other default prone loans and securities. This comprises over 1/3 of their risk portfolios and amounts to 34% of all the subprime loans and 60% of all Alt-A loans outstanding. These 10.5 million unsustainable, nonprime loans are experiencing a default rate 8 times the level of the GSEs’ 20 million traditional quality loans. The GSEs will be responsible for a large percentage of an estimated 8.8 million foreclosures expected over the next 4 years, accounting for the failure of about 1 in 6 home mortgages. Fannie and Freddie have subprimed America.”

In perceptive analysis of growth and macroeconomics in the past six decades, Rajan (2012FA) argues that “the West can’t borrow and spend its way to recovery.” The Keynesian paradigm is not applicable in current conditions. Advanced economies in the West could be divided into those that reformed regulatory structures to encourage productivity and others that retained older structures. In the period from 1950 to 2000, Cobet and Wilson (2002) find that US productivity, measured as output/hour, grew at the average yearly rate of 2.9 percent while Japan grew at 6.3 percent and Germany at 4.7 percent (see Pelaez and Pelaez, The Global Recession Risk (2007), 135-44). In the period from 1995 to 2000, output/hour grew at the average yearly rate of 4.6 percent in the US but at lower rates of 3.9 percent in Japan and 2.6 percent in Germany. Rajan (2012FA) argues that the differential in productivity growth was accomplished by deregulation in the US at the end of the 1970s and during the 1980s. In contrast, Europe did not engage in reform with the exception of Germany in the early 2000s that empowered the German economy with significant productivity advantage. At the same time, technology and globalization increased relative remunerations in highly-skilled, educated workers relative to those without skills for the new economy. It was then politically appealing to improve the fortunes of those left behind by the technological revolution by means of increasing cheap credit. As Rajan (2012FA) argues:

“In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, partly to gain more control over Fannie Mae and Freddie Mac, the giant private mortgage agencies, and partly to promote affordable homeownership for low-income groups. Such policies helped money flow to lower-middle-class households and raised their spending—so much so that consumption inequality rose much less than income inequality in the years before the crisis. These policies were also politically popular. Unlike when it came to an expansion in government welfare transfers, few groups opposed expanding credit to the lower-middle class—not the politicians who wanted more growth and happy constituents, not the bankers and brokers who profited from the mortgage fees, not the borrowers who could now buy their dream houses with virtually no money down, and not the laissez-faire bank regulators who thought they could pick up the pieces if the housing market collapsed. The Federal Reserve abetted these shortsighted policies. In 2001, in response to the dot-com bust, the Fed cut short-term interest rates to the bone. Even though the overstretched corporations that were meant to be stimulated were not interested in investing, artificially low interest rates acted as a tremendous subsidy to the parts of the economy that relied on debt, such as housing and finance. This led to an expansion in housing construction (and related services, such as real estate brokerage and mortgage lending), which created jobs, especially for the unskilled. Progressive economists applauded this process, arguing that the housing boom would lift the economy out of the doldrums. But the Fed-supported bubble proved unsustainable. Many construction workers have lost their jobs and are now in deeper trouble than before, having also borrowed to buy unaffordable houses. Bankers obviously deserve a large share of the blame for the crisis. Some of the financial sector’s activities were clearly predatory, if not outright criminal. But the role that the politically induced expansion of credit played cannot be ignored; it is the main reason the usual checks and balances on financial risk taking broke down.”

In fact, Raghuram G. Rajan (2005) anticipated low liquidity in financial markets resulting from low interest rates before the financial crisis that caused distortions of risk/return decisions provoking the credit/dollar crisis and global recession from IVQ2007 to IIQ2009. Near zero interest rates of unconventional monetary policy induced excessive risks and low liquidity in financial decisions that were critical as a cause of the credit/dollar crisis after 2007. Rajan (2012FA) argues that it is not feasible to return to the employment and income levels before the credit/dollar crisis because of the bloated construction sector, financial system and government budgets.

(4) Historically Sharper Recoveries from Deeper Contractions and Financial Crises. Professor Michael D. Bordo (2012Sep27), at Rutgers University, is providing clear thought on the correct comparison of the current business cycles in the United States with those in United States history. There are two issues raised by Professor Bordo: (1) lumping together countries with different institutions, economic policies and financial systems; and (2) the conclusion that growth is mediocre after financial crises and deep recessions, which is repeated daily in the media, but that Bordo and Haubrich (2012DR) persuasively demonstrate to be inconsistent with United States experience.

Depriving economic history of institutions is perilous as is illustrated by the economic history of Brazil. Douglass C. North (1994) emphasized the key role of institutions in explaining economic history. Rondo E. Cameron (1961, 1967, 1972) applied institutional analysis to banking history. Friedman and Schwartz (1963) analyzed the relation of money, income and prices in the business cycle and related the monetary policy of an important institution, the Federal Reserve System, to the Great Depression. Bordo, Choudhri and Schwartz (1995) analyze the counterfactual of what would have been economic performance if the Fed had used during the Great Depression the Friedman (1960) monetary policy rule of constant growth of money(for analysis of the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 198-217). Alan Meltzer (2004, 2010a,b) analyzed the Federal Reserve System over its history. The reader would be intrigued by Figure 5 in Reinhart and Rogoff (2010FCDC, 15) in which Brazil is classified in external default for seven years between 1828 and 1834 but not again until 64 years later in 1989, above the 50 years of incidence for “serial default”. This void has been filled in scholarly research on nineteenth-century Brazil by William R. Summerhill, Jr. (2007SC, 2007IR). There are important conclusions by Summerhill on the exceptional sample of institutional change or actually lack of change, public finance and financial repression in Brazil between 1822 an 1899, combining tools of economics, political science and history. During seven continuous decades, Brazil did not miss a single interest payment with government borrowing without repudiation of debt or default. What is really surprising is that Brazil borrowed by means of long-term bonds and even more surprising interest rates fell over time. The external debt of Brazil in 1870 was ₤41,275,961 and the domestic debt in the internal market was ₤25,708,711, or 62.3 percent of the total (Summerhill 2007IR, 73).

The experience of Brazil differed from that of Latin America (Summerhill 2007IR). During the six decades when Brazil borrowed without difficulty, Latin American countries becoming independent after 1820 engaged in total defaults, suffering hardship in borrowing abroad. The countries that borrowed again fell again in default during the nineteenth century. Venezuela defaulted in four occasions. Mexico defaulted in 1827, rescheduling its debt eight different times and servicing the debt sporadically. About 44 percent of Latin America’s sovereign debt was in default in 1855 and approximately 86 percent of total government loans defaulted in London originated in Spanish American borrowing countries.

External economies of commitment to secure private rights in sovereign credit would encourage development of private financial institutions, as postulated in classic work by North and Weingast (1989), Summerhill 2007IR, 22). This is how banking institutions critical to the Industrial Revolution were developed in England (Cameron 1967). The obstacle in Brazil found by Summerhill (2007IR) is that sovereign debt credibility was combined with financial repression. There was a break in Brazil of the chain of effects from protecting public borrowing, as in North and Weingast (1989), to development of private financial institutions. According to Pelaez 1976, 283) following Cameron:

“The banking law of 1860 placed severe restrictions on two basic modern economic institutions—the corporation and the commercial bank. The growth of the volume of bank credit was one of the most significant factors of financial intermediation and economic growth in the major trading countries of the gold standard group. But Brazil placed strong restrictions on the development of banking and intermediation functions, preventing the channeling of coffee savings into domestic industry at an earlier date.”

Brazil actually abandoned the gold standard during multiple financial crises in the nineteenth century, as it should have to protect domestic economic activity. Pelaez (1975, 447) finds similar experience in the first half of nineteenth-century Brazil:

“Brazil’s experience is particularly interesting in that in the period 1808-1851 there were three types of monetary systems. Between 1808 and 1829, there was only one government-related Bank of Brazil, enjoying a perfect monopoly of banking services. No new banks were established in the 1830s after the liquidation of the Bank of Brazil in 1829. During the coffee boom in the late 1830s and 1840s, a system of banks of issue, patterned after similar institutions in the industrial countries [Cameron 1967], supplied the financial services required in the first stage of modernization of the export economy.”

Financial crises in the advanced economies were transmitted to nineteenth-century Brazil by the arrival of a ship (Pelaez and Suzigan 1981). The explanation of those crises and the economy of Brazil requires knowledge and roles of institutions, economic policies and the financial system chosen by Brazil, in agreement with Bordo (2012Sep27).

The departing theoretical framework of Bordo and Haubrich (2012DR) is the plucking model of Friedman (1964, 1988). Friedman (1988, 1) recalls “I was led to the model in the course of investigating the direction of influence between money and income. Did the common cyclical fluctuation in money and income reflect primarily the influence of money on income or of income on money?” Friedman (1964, 1988) finds useful for this purpose to analyze the relation between expansions and contractions. Analyzing the business cycle in the United States between 1870 and 1961, Friedman (1964, 15) found that “a large contraction in output tends to be followed on the average by a large business expansion; a mild contraction, by a mild expansion.” The depth of the contraction opens up more room in the movement toward full employment (Friedman 1964, 17):

“Output is viewed as bumping along the ceiling of maximum feasible output except that every now and then it is plucked down by a cyclical contraction. Given institutional rigidities and prices, the contraction takes in considerable measure the form of a decline in output. Since there is no physical limit to the decline short of zero output, the size of the decline in output can vary widely. When subsequent recovery sets in, it tends to return output to the ceiling; it cannot go beyond, so there is an upper limit to output and the amplitude of the expansion tends to be correlated with the amplitude of the contraction.”

Kim and Nelson (1999) test the asymmetric plucking model of Friedman (1964, 1988) relative to a symmetric model using reference cycles of the NBER and find evidence supporting the Friedman model. Bordo and Haubrich (2012DR) analyze 27 cycles beginning in 1872, using various measures of financial crises while considering different regulatory and monetary regimes. The revealing conclusion of Bordo and Haubrich (2012DR, 2) is that:

“Our analysis of the data shows that steep expansions tend to follow deep contractions, though this depends heavily on when the recovery is measured. In contrast to much conventional wisdom, the stylized fact that deep contractions breed strong recoveries is particularly true when there is a financial crisis. In fact, on average, it is cycles without a financial crisis that show the weakest relation between contraction depth and recovery strength. For many configurations, the evidence for a robust bounce-back is stronger for cycles with financial crises than those without.”

The average rate of growth of real GDP in expansions after recessions with financial crises was 8 percent but only 6.9 percent on average for recessions without financial crises (Bordo 2012Sep27). Real GDP declined 12 percent in the Panic of 1907 and increased 13 percent in the recovery, consistent with the plucking model of Friedman (Bordo 2012Sep27). Bordo (2012Sep27) finds two probable explanations for the weak recovery during the current economic cycle: (1) collapse of United States housing; and (2) uncertainty originating in fiscal policy, regulation and structural changes. There are serious doubts if monetary policy is adequate to recover the economy under these conditions.

Lucas (2011May) estimates US economic growth in the long-term at 3 percent per year and about 2 percent per year in per capita terms. There are displacements from this trend caused by events such as wars and recessions but the economy then returns to trend. Historical US GDP data exhibit remarkable growth: Lucas (2011May) estimates an increase of US real income per person by a factor of 12 in the period from 1870 to 2010. The explanation by Lucas (2011May) of this remarkable growth experience is that government provided stability and education while elements of “free-market capitalism” were an important driver of long-term growth and prosperity. The analysis is sharpened by comparison with the long-term growth experience of G7 countries (US, UK, France, Germany, Canada, Italy and Japan) and Spain from 1870 to 2010. Countries benefitted from “common civilization” and “technology” to “catch up” with the early growth leaders of the US and UK, eventually growing at a faster rate. Significant part of this catch up occurred after World War II. Lucas (2011May) finds that the catch up stalled in the 1970s. The analysis of Lucas (2011May) is that the 20-40 percent gap that developed originated in differences in relative taxation and regulation that discouraged savings and work incentives in comparison with the US. A larger welfare and regulatory state, according to Lucas (2011May), could be the cause of the 20-40 percent gap. Cobet and Wilson (2002) provide estimates of output per hour and unit labor costs in national currency and US dollars for the US, Japan and Germany from 1950 to 2000 (see Pelaez and Pelaez, The Global Recession Risk (2007), 137-44). The average yearly rate of productivity change from 1950 to 2000 was 2.9 percent in the US, 6.3 percent for Japan and 4.7 percent for Germany while unit labor costs in USD increased at 2.6 percent in the US, 4.7 percent in Japan and 4.3 percent in Germany. From 1995 to 2000, output per hour increased at the average yearly rate of 4.6 percent in the US, 3.9 percent in Japan and 2.6 percent in Germany while unit labor costs in USD fell at minus 0.7 percent in the US, 4.3 percent in Japan and 7.5 percent in Germany. There was increase in productivity growth in Japan and France within the G7 in the second half of the 1990s but significantly lower than the acceleration of 1.3 percentage points per year in the US. Long-term economic growth and prosperity are measured by the key indicators of growth of real income per capita, or what is earned per person after inflation. A refined concept would include real disposable income per capita, or what is earned per person after inflation and taxes.

Table IB-1 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IVQ1985 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IVQ1985, GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.5 percent at the annual equivalent rate of 4.3 percent; RDPI per capita increased 11.5 percent at the annual equivalent rate of 3.4 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. Second, in the 13 quarters of the current cyclical expansion from IIIQ2009 to IIIQ2012, GDP increased 7.2 percent at the annual equivalent rate of 2.2 percent. In the 12 quarters of cyclical expansion real disposable personal income (RDPI) increased 5.7 percent at the annual equivalent rate of 1.7 percent; RDPI per capita increased 3.3 percent at the annual equivalent rate of 1.0 percent; and population increased 2.3 percent at the annual equivalent rate of 0.7 percent. Third, since the beginning of the recession in IVQ2007 to IIIQ2012, GDP increased 2.2 percent, or barely above the level before the recession. Since the beginning of the recession in IVQ2007 to IIIQ2012, real disposable personal income increased 3.7 percent at the annual equivalent rate of 0.7 percent; population increased 3.9 percent at the annual equivalent rate of 0.8 percent; and real disposable personal income per capita is 0.2 percent lower than the level before the recession. Real disposable personal income is the actual take home pay after inflation and taxes and real disposable income per capita is what is left per inhabitant. The current cyclical expansion is the worst in the period after World War II in terms of growth of economic activity and income. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction from IVQ2007 to IIQ2009 of 4.7 percent and the financial crisis.

Table IB-1, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2011, %

	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IVQ1985	13
GDP		19.6	5.7
RDPI		14.5	4.3
RDPI Per Capita		11.5	3.4
Population		2.7	0.8
IIIQ2009 to IIIQ2012	13
GDP		7.2	2.2
RDPI		5.7	1.7
RDPI per Capita		3.3	1.0
Population		2.3	0.7
IVQ2007 to IIIQ2012	20
GDP		2.2	0.4
RDPI		3.7	0.7
RDPI per Capita		-0.2
Population		3.9	0.8

RDPI: Real Disposable Personal Income

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

There are seven basic facts illustrating the current economic disaster of the United States: (1) GDP maintained trend growth in the entire business cycle from IQ1980 to IV1985, including contractions and expansions, but is well below trend in the entire business cycle from IVQ2007 to IIQ2012, including contractions and expansions; (2) per capita real disposable income exceeded trend growth in the 1980s but is substantially below trend in IIQ2012; (3) the number of employed persons increased in the 1980s but declined into IIQ2012; (4) the number of full-time employed persons increased in the 1980s but declined into IIIQ2012; (5) the number unemployed, unemployment rate and number employed part-time for economic reasons fell in the recovery from the recessions of the 1980s but not substantially in the recovery after IIQ2009; (6) wealth of households and nonprofit organizations soared in the 1980s but declined into IIQ2012; and (7) gross private domestic investment increased sharply from IQ1980 to IVQ1985 but gross private domestic investment and private fixed investment have fallen sharply from IVQ2007 to IIIQ2007. There is a critical issue of whether the United States economy will be able in the future to attain again the level of activity and prosperity of projected trend growth. Growth at trend during the entire business cycles built the largest economy in the world but there may be an adverse, permanent weakness in United States economic performance and prosperity. Table IB-2 provides data for analysis of these five basic facts. The six blocks of Table IB-2 are separated initially after individual discussion of each one followed by the full Table IB-2.

1. Trend Growth.

i. As shown in Table IB-2, actual GDP grew cumulatively 17.7 percent from IQ1980 to IVQ1985, which is relatively close to what trend growth would have been at 18.5 percent. Rapid growth at 5.7 percent annual rate on average per quarter during the expansion from IQ1983 to IVQ1985 erased the loss of GDP of 4.8 percent during the contraction and maintained trend growth at 3 percent over the entire cycle.

ii. In contrast, cumulative growth from IVQ2007 to IIIQ2012 was 2.2 percent while trend growth would have been 15.1 percent. GDP in IIIQ2012 at seasonally adjusted annual rate is estimated at $13,616.2 by the Bureau of Economic Analysis (BEA) (http://www.bea.gov/iTable/index_nipa.cfm) and would have been $15,338.2 billion, or $1,722 billion higher, had the economy grown at trend over the entire business cycle as it happened during the 1980s and throughout most of US history. There is $1.7 trillion of foregone GDP that would have been created as it occurred during past cyclical expansions, which explains why employment has not rebounded to even higher than before. There would not be recovery of full employment even with growth of 3 percent per year beginning immediately because the opportunity was lost to grow faster during the expansion from IIIQ2009 to IIIQ2012 after the recession from IVQ2007 to IIQ2009. The United States has acquired a heavy social burden of unemployment and underemployment of 28.1 million people or 17.4 percent of the effective labor force (Section I, Table I-4 http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html) that will not be significantly diminished even with return to growth of GDP of 3 percent per year because of growth of the labor force by new entrants. The US labor force grew from 142.583 million in 2000 to 153.124 million in 2007 or by 7.4 percent at the average yearly rate of 1.0 percent per year. The civilian noninstitutional population increased from 212.577 million in 2000 to 231.867 million in 2007 or 9.1 percent at the average yearly rate of 1.3 percent per year (data from http://www.bls.gov/data/). Data for the past five years cloud accuracy because of the number of people discouraged from seeking employment. The noninstitutional population of the United States increased from 231.867 million in 2007 to 239.618 million in 2011 or by 3.3 percent while the labor force increased from 153.124 million in 2007 to 153.617 million in 2011 or by 0.3 percent (data from http://www.bls.gov/data/). People ceased to seek jobs because they do not believe that there is a job available for them (http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html ).

Period IQ1980 to IVQ1985
GDP SAAR USD Billions
IQ1980	5,903.4
IVQ1985	6,950.0
∆% IQ1980 to IVQ1985	17.7
∆% Trend Growth IQ1980 to IVQ1985	18.5

Period IVQ2007 to IIIQ2012
GDP SAAR USD Billions
IVQ2007	13,326.0
IIIQ2012	13,616.2
∆% IVQ2007 to IIIQ2012 Actual	2.2
∆% IVQ2007 to IIIQ2012 Trend	15.1

2. Decline of Per Capita Real Disposable Income

i. In the entire business cycle from IQ1980 to IVQ1985, as shown in Table IB-2 trend growth of per capita real disposable income, or what is left per person after inflation and taxes, grew cumulatively 14.5 percent, which is close to what would have been trend growth of 12.1 percent.

ii. In contrast, in the entire business cycle from IVQ2007 to IIIQ2012, per capita real disposable income fell 0.2 percent while trend growth would have been 10.4 percent. Income available after inflation and taxes is lower than before the contraction after 13 consecutive quarters of GDP growth at mediocre rates relative to those prevailing during historical cyclical expansions.

Period IQ1980 to IVQ1985

Real Disposable Personal Income per Capita IQ1980 Chained 2005 USD	18,938
Real Disposable Personal Income per Capita IVQ1985 Chained 2005 USD	21,687
∆% IQ1980 to IVQ1985	14.5
∆% Trend Growth	12.1

Period IVQ2007 to IIIQ2012

Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IIIQ2012 Chained 2005 USD	32,778
∆% IVQ2007 to IIIQ2012	-0.2
∆% Trend Growth	10.4

3. Number of Employed Persons

i. As shown in Table IB-2, the number of employed persons increased over the entire business cycle from 98.527 million not seasonally adjusted (NSA) in IQ1980 to 107.819 million NSA in IVQ1985 or by 9.4 percent.

ii. In contrast, during the entire business cycle the number employed fell from 146.334 million in IVQ2007 to 143.202 million in IIIQ2012 or by 2.1 percent. There are 28.1 million persons unemployed or underemployed, which is 17.4 percent of the effective labor force (Section I, Table I-4 http://cmpassocregulationblog.blogspot.com/2012/11/twenty-eight-million-unemployed-or.html).

Period IQ1980 to IVQ1985

Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IV1985 NSA End of Quarter	107.819
∆% Employed IQ1980 to IV1985	9.4

Period IVQ2007 to IIIQ2012

Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIIQ2012 NSA End of Quarter	143.333
∆% Employed IVQ2007 to IIIQ2012	-2.1

4. Number of Full-Time Employed Persons

i. As shown in Table IB-2, during the entire business cycle in the 1980s, including contractions and expansion, the number of employed full-time rose from 81.280 million NSA in IQ1980 to 88.757 million NSA in IVQ1985 or 9.2 percent.

ii. In contrast, during the entire current business cycle, including contraction and expansion, the number of persons employed full-time fell from 121.042 million in IVQ2007 to 115.678 million in IIIQ2012 or by minus 4.4 percent.

Period IQ1980 to IVQ1985

Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IV1985 NSA End of Quarter	88.757
∆% Full-time Employed IQ1980 to IV1985	9.2

Period IVQ2007 to IIIQ2012

Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIIQ2012 NSA End of Quarter	115.678
∆% Full-time Employed IVQ2007 to IIIQ2012	-4.4

5. Unemployed, Unemployment Rate and Employed Part-time for Economic Reasons.

i. As shown in Table IB-2 and in the following block, in the cycle from IQ1980 to IVQ1985: (a) the rate of unemployment was virtually the same at 6.7 percent in IQ1985 relative to 6.6 percent in IQ1980; (b) the number unemployed increased from 6.983 million in IQ1980 to 7.717 million in IVQ1985 or 10.5 percent; and (c) the number employed part-time for economic reasons increased 49.1 percent from 3.624 million in IQ1980 to 5.402 million in IVQ1985.

ii. In contrast, in the economic cycle from IVQ2007 to IIIQ2012: (a) the rate of unemployment increased from 4.8 percent in IVQ2007 to 7.6 percent in IIIQ2012; (b) the number unemployed increased 59.3 percent from 7.371 million in IVQ2007 to 11.742 million in IIIQ2012; (c) the number employed part-time for economic reasons increased 70.7 percent from 4.750 million in IVQ2007 to 8.110 million in IIIQ2012; and (d) U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA increased from 8.7 percent in IVQ2007 to 14.2 percent in IIIQ2012.

Period IQ1980 to IVQ1985

Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate IV1985 NSA End of Quarter	6.7
Unemployed IQ1980 Millions End of Quarter	6.983
Unemployed IV 1985 Millions End of Quarter	7.717
Employed Part-time Economic Reasons Millions IQ1980 End of Quarter	3.624
Employed Part-time Economic Reasons Millions IVQ1985 End of Quarter	5.402
∆%	49.1

Period IVQ2007 to IIIQ2012

Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIIQ2012 NSA End of Quarter	7.6
Unemployed IVQ2007 Millions End of Quarter	7.371
Unemployed IIIQ2009 Millions End of Quarter	11.742
∆%	59.3
Employed Part-time Economic Reasons IVQ2007 Millions End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIIQ2009 End of Quarter	8.110
∆%	70.7
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IIIQ2012	14.2

6. Wealth of Households and Nonprofit Organizations.

i. The comparison of net worth of households and nonprofit organizations in the entire economic cycle from IQ1980 (and also from IVQ1979) to IVQ1985 and from IVQ2007 to IIQ2012 is provided in the following block and in Table IB-2. Net worth of households and nonprofit organizations increased from $8,326.4 billion in IVQ1979 to $14,395.2 billion in IVQ1985 or 72.9 percent or 69.3 percent from $8,502.9 billion in IQ1980. The starting quarter does not bias the results. The US consumer price index not seasonally adjusted increased from 76.7 in Dec 1979 to 109.3 in Dec 1985 or 42.5 percent or 36.5 percent from 80.1 in Mar 1980 (using consumer price index data from the US Bureau of Labor Statistics at http://www.bls.gov/cpi/data.htm). In terms of purchasing power measured by the consumer price index, real wealth of households and nonprofit organizations increased 21.3 percent in constant purchasing power from IVQ1979 to IVQ1985 or 24.0 percent from IQ1980.

ii. In contrast, as shown in the following block and in Table IB-2, net worth of households and nonprofit organizations fell from $66,057.1 billion in IVQ2007 to $62,668.4 billion in IIQ2012 by $3,388.7 billion or 5.1 percent. The US consumer price index was 210.036 in Dec 2007 and 229.478 in Jun 2012 for increase of 9.3 percent. In purchasing power of Dec 2007, wealth of households and nonprofit organizations is lower by 13.2 percent in Jun 2012 after 12 consecutive quarters of expansion from IIIQ2009 to IIQ2012 relative to IVQ2012 when the recession began. The explanation is partly in the sharp decline of wealth of households and nonprofit organizations and partly in the mediocre growth rates of the cyclical expansion beginning in IIIQ2009. The average growth rate from IIIQ2009 to IIQ2012 has been 2.2 percent, which is substantially lower than the average of 6.2 percent in cyclical expansions after World War II and 5.7 percent in the expansion from IQ1983 to IVQ1985 (see Table I-5 http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html). The US missed the opportunity of high growth rates that has been available in past cyclical expansions.

Period IQ1980 to IVQ1985
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	8,326.4
IVQ1985	14,395.2
∆ USD Billions	+6,068.8
Period IVQ2007 to IIQ2012
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	66,057.1
IIQ2012	62,668.4
∆ USD Billions	-3,388.7

7. Gross Private Domestic Investment.

i. The comparison of gross private domestic investment in the entire economic cycles from IQ1980 to IV1985 and from IVQ2007 to IIQ2012 is provides in the following block and in Table IB-2. Gross private domestic investment increased from $778.3 billion in IQ1980 to $965.9 billion in IVQ1985 or by 24.1 percent.

ii In the current cycle, gross private domestic investment decreased from $2,123.6 billion in IVQ2007 to $1,900.9 billion in IIIQ2012, or decline by 10.5 percent. Private fixed investment fell from $2,111.5 billion in IVQ2007 to $1847.6 billion in IIIQ2012, or decline by 12.5 percent.

Period IQ1980 to IVQ1985
Gross Private Domestic Investment USD 2005 Billions
IQ1980	778.3
IVQ1985	965.9
∆%	24.1
Period IVQ2007 to IIIQ2012
Gross Private Domestic Investment USD Billions
IVQ2007	2,123.6
IIIQ2012	1,900.9
∆%	-10.5
Private Fixed Investment USD 2005 Billions
IVQ2007	2,111.5
IIIQ2012	1847.6
∆%	-12.5

Table IB-2, US, GDP and Real Disposable Personal Income per Capita Actual and Trend Growth and Employment, 1980-1985 and 2007-2012, SAAR USD Billions, Millions of Persons and ∆%


Period IQ1980 to IVQ1985
GDP SAAR USD Billions
IQ1980	5,903.4
IVQ1985	6,950.0
∆% IQ1980 to IVQ1985	17.7
∆% Trend Growth IQ1980 to IVQ1985	18.5
Real Disposable Personal Income per Capita IQ1980 Chained 2005 USD	18,938
Real Disposable Personal Income per Capita IVQ1985 Chained 2005 USD	21,687
∆% IQ1980 to IVQ1985	14.5
∆% Trend Growth	12.1
Employed Millions IQ1980 NSA End of Quarter	98.527
Employed Millions IV1985 NSA End of Quarter	107.819
∆% Employed IQ1980 to IV1985	9.4
Employed Full-time Millions IQ1980 NSA End of Quarter	81.280
Employed Full-time Millions IV1985 NSA End of Quarter	88.757
∆% Full-time Employed IQ1980 to IV1985	9.2
Unemployment Rate IQ1980 NSA End of Quarter	6.6
Unemployment Rate IV1985 NSA End of Quarter	6.7
Unemployed IQ1980 Millions NSA End of Quarter	6.983
Unemployed IV 1985 Millions NSA End of Quarter	7.717
∆%	11.9
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIQ2009 NSA End of Quarter	8.394
∆%	76.7
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ1979	8,326.4
IVQ1985	14,395.2
∆ USD Billions	+6,068.8
Gross Private Domestic Investment USD 2005 Billions
IQ1980	778.3
IVQ1985	965.9
∆%	24.1
Period IVQ2007 to IIIQ2012
GDP SAAR USD Billions
IVQ2007	13,326.0
IIIQ2012	13,616.2
∆% IVQ2007 to IIIQ2012	2.2
∆% IVQ2007 to IIIQ2012 Trend Growth	15.1
Real Disposable Personal Income per Capita IVQ2007 Chained 2005USD	32,837
Real Disposable Personal Income per Capita IIIQ2012 Chained 2005 USD	32,778
∆% IVQ2007 to IIIQ2012	-0.2
∆% Trend Growth	10.4
Employed Millions IVQ2007 NSA End of Quarter	146.334
Employed Millions IIIQ2012 NSA End of Quarter	143.333
∆% Employed IVQ2007 to IIIQ2012	-2.1
Employed Full-time Millions IVQ2007 NSA End of Quarter	121.042
Employed Full-time Millions IIIQ2012 NSA End of Quarter	115.678
∆% Full-time Employed IVQ2007 to IIIQ2012	-4.4
Unemployment Rate IVQ2007 NSA End of Quarter	4.8
Unemployment Rate IIIQ2012 NSA End of Quarter	7.6
Unemployed IVQ2007 Millions NSA End of Quarter	7.371
Unemployed IIIQ2009 Millions NSA End of Quarter	11.742
∆%	59.3
Employed Part-time Economic Reasons IVQ2007 Millions NSA End of Quarter	4.750
Employed Part-time Economic Reasons Millions IIIQ2009 NSA End of Quarter	8.110
∆%	70.7
U6 Total Unemployed plus all marginally attached workers plus total employed part time for economic reasons as percent of all civilian labor force plus all marginally attached workers NSA
IVQ2007	8.7
IIIQ2012	14.2
Net Worth of Households and Nonprofit Organizations USD Billions
IVQ2007	66,057.1
IIQ2012	62,668.4
∆ USD Billions	-3,388.7
Gross Private Domestic Investment USD Billions
IVQ2007	2,123.6
IIIQ2012	1,900.9
∆%	-10.5
Private Fixed Investment USD 2005 Billions
IVQ2007	2,111.5
IIIQ2012	1847.6
∆%	-12.5

Note: GDP trend growth used is 3.0 percent per year and GDP per capita is 2.0 percent per year as estimated by Lucas (2011May) on data from 1870 to 2010.

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm US Bureau of Labor Statistics http://www.bls.gov/data/. Board of Governors of the Federal Reserve System. 2012Sep20. Flow of funds accounts of the United States. Washington, DC, Federal Reserve System.

II United States Commercial Banks Assets and Liabilities. Subsection IIA Transmission of Monetary Policy recapitulates the mechanism of transmission of monetary policy. Subsection IIB Functions of Banking analyzes the functions of banks in modern banking theory. Subsection IIC United States Commercial Bank Assets and Liabilities provides data and analysis of US commercial bank balance sheets in report H.8 of the Board of Governors of the Federal Reserve System on Assets and Liabilities of Commercial Banks in the United States (http://www.federalreserve.gov/releases/h8/current/default.htm).

IIA Transmission of Monetary Policy. The critical fact of current world financial markets is the combination of “unconventional” monetary policy with intermittent shocks of financial risk aversion. There are two interrelated unconventional monetary policies. First, unconventional monetary policy consists of (1) reducing short-term policy interest rates toward the “zero bound” such as fixing the fed funds rate at 0 to ¼ percent by decision of the Federal Open Market Committee (FOMC) since Dec 16, 2008 (http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm). Second, unconventional monetary policy also includes a battery of measures to also reduce long-term interest rates of government securities and asset-backed securities such as mortgage-backed securities.

When inflation is low, the central bank lowers interest rates to stimulate aggregate demand in the economy, which consists of consumption and investment. When inflation is subdued and unemployment high, monetary policy would lower interest rates to stimulate aggregate demand, reducing unemployment. When interest rates decline to zero, unconventional monetary policy would consist of policies such as large-scale purchases of long-term securities to lower their yields. A major portion of credit in the economy is financed with long-term asset-backed securities. Loans for purchasing houses, automobiles and other consumer products are bundled in securities that in turn are sold to investors. Corporations borrow funds for investment by issuing corporate bonds. Loans to small businesses are also financed by bundling them in long-term bonds. Securities markets bridge the needs of higher returns by investors obtaining funds from savers that are channeled to consumers and business for consumption and investment. Lowering the yields of these long-term bonds could lower costs of financing purchases of consumer durables and investment by business. The essential mechanism of transmission from lower interest rates to increases in aggregate demand is portfolio rebalancing. Withdrawal of bonds in a specific maturity segment or directly in a bond category such as currently mortgage-backed securities causes reductions in yield that are equivalent to increases in the prices of the bonds. There can be secondary increases in purchases of those bonds in private portfolios in pursuit of their increasing prices. Lower yields translate into lower costs of buying homes and consumer durables such as automobiles and also lower costs of investment for business. There are two additional intended routes of transmission.

1. Unconventional monetary policy or its expectation can increase stock market valuations (Bernanke 2010WP). Increases in equities traded in stock markets can augment perceptions of the wealth of consumers inducing increases in consumption.

2. Unconventional monetary policy causes devaluation of the dollar relative to other currencies, which can cause increases in net exports of the US that increase aggregate economic activity (Yellen 2011AS).

Monetary policy can lower short-term interest rates quite effectively. Lowering long-term yields is somewhat more difficult. The critical issue is that monetary policy cannot ensure that increasing credit at low interest cost increases consumption and investment. There is a large variety of possible allocation of funds at low interest rates from consumption and investment to multiple risk financial assets. Monetary policy does not control how investors will allocate asset categories. A critical financial practice is to borrow at low short-term interest rates to invest in high-risk, leveraged financial assets. Investors may increase in their portfolios asset categories such as equities, emerging market equities, high-yield bonds, currencies, commodity futures and options and multiple other risk financial assets including structured products. If there is risk appetite, the carry trade from zero interest rates to risk financial assets will consist of short positions at short-term interest rates (or borrowing) and short dollar assets with simultaneous long positions in high-risk, leveraged financial assets such as equities, commodities and high-yield bonds. Low interest rates may induce increases in valuations of risk financial assets that may fluctuate in accordance with perceptions of risk aversion by investors and the public. During periods of muted risk aversion, carry trades from zero interest rates to exposures in risk financial assets cause temporary waves of inflation that may foster instead of preventing financial instability (http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html). During periods of risk aversion such as fears of disruption of world financial markets and the global economy resulting from collapse of the European Monetary Union, carry trades are unwound with sharp deterioration of valuations of risk financial assets. More technical discussion is in IA Appendix: Transmission of Unconventional Monetary Policy at http://cmpassocregulationblog.blogspot.com/2012/11/united-states-unsustainable-fiscal.html.

It may be quite painful to exit QE∞ or use of the balance sheet of the central bank together with zero interest rates forever. The basic valuation equation that is also used in capital budgeting postulates that the value of stocks or of an investment project is given by:

Where R_τ is expected revenue in the time horizon from τ =1 to T; C_τ denotes costs; and ρ is an appropriate rate of discount. In words, the value today of a stock or investment project is the net revenue, or revenue less costs, in the investment period from τ =1 to T discounted to the present by an appropriate rate of discount. In the current weak economy, revenues have been increasing more slowly than anticipated in investment plans. An increase in interest rates would affect discount rates used in calculations of present value, resulting in frustration of investment decisions. If V represents value of the stock or investment project, as ρ → ∞, meaning that discount rates increase without bound, then V → 0, or

declines.

W = Y/r (1)

Equation (1) shows that as r goes to zero, r →0, W grows without bound, W→∞. Equally, as r→∞, W→0. Monetary policy is constrained in a QE∞ trap with all adverse effects of financial repression and resource misallocation because an increase in interest rates causes contraction of wealth, which in the United States is concentrated in home ownership and stocks in own investment portfolios and pension funds that decline during interest rate increases.

IIB Functions of Banks. Modern banking theory analyzes three important functions provided by banks: monitoring of borrowers, provision of liquidity services and transformation of illiquid assets into immediately liquid assets (Pelaez and Pelaez, Regulation of Banks and Finance (2009b), 51-60). These functions require valuation of alternative investment projects that may be distorted by zero interest rates of monetary policy and artificially low long-term interest rates. The QE∞ trap frustrates essential banking functions.

1. Monitoring. Banks monitor projects to ensure that funds are allocated to their intended projects (Diamond 1984, 1996). Banks issue deposits, which are secondary assets, to acquire loans, which are primary assets. Monitoring reduces costs of participating in business projects. Acting as delegated monitor, banks obtain information on the borrower, allowing less costly participation through the issue of unmonitored deposits. Monitoring of borrowers provides enhanced less costly participation by investors through the issue of deposits. There is significant reduction of monitoring costs by delegating to a bank. If there are many potential investors, monitoring by the bank of a credit name is less costly than the sum of individual monitoring of the same credit name by all potential investors. Banks permit borrowers to reach many investors for their projects while affording investors less costly participation in the returns of projects of bank borrowers.

2. Transformation of Illiquid Loans into Liquid Deposits. Diamond and Dybvig (1986) analyze bank services through their balance sheets.

i. Assets. Banks provide loans to borrowers. The evaluation of borrowers prevents “adverse selection,” which consists of banks choosing unsound projects and failing to finance sound projects. Monitoring of loans prevents “moral hazard,” which consists of borrowers using the funds of the loan for purposes other than the project for which they were lent, as for example, using borrowed bank funds for speculative real estate instead of for the intended industrial project. Relationship banking improves the information on borrowers and the monitoring function.

ii. Liabilities. Banks provide numerous services to their clients such as holding deposits, clearing transactions, currency inventory and payments for goods, services and obligations.

iii. Assets and Liabilities: Transformation Function. The transformation function operates through both sides of the balance sheet: banks convert illiquid loans in the asset side into liquid deposits in the liability side. There is rich theory of banking (Diamond and Rajan 2000, 2001a,b). Securitized banking provides the same transformation function by bundling mortgage and other consumer loans into securities that are then sold to investors who finance them in short-dated sale and repurchase agreements (Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 61-6).

Banking was important in facilitating economic growth in historical periods (Cameron 1961, 1967, 1972; Cameron et al. 1992). Banking is also important currently because small- and medium-size business may have no other form of financing than banks in contrast with many options for larger and more mature companies that have access to capital markets. Personal consumptions expenditures have share of 70.8 percent of GDP in IIIQ2012 (Table I-10 http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html). Most consumers rely on their banks for real estate loans, credit cards and personal consumer loans. Thus, it should be expected that success of monetary policy in stimulating the economy would be processed through bank balance sheets.

IIC United States Commercial Banks Assets and Liabilities. Data and analysis on US commercial bank assets and liabilities are introduced below in two forms: two tables provide not seasonally adjusted (NSA) assets and liabilities from Oct 2011 to Oct 2012 and seasonally adjusted annual rates of percentage change (SAAR); and a group of charts permits different perspectives of longer historical series.

Selected assets and liabilities of US commercial banks, not seasonally adjusted, in billions of dollars, from Report H.8 of the Board of Governors of the Federal Reserve System are provided in Table II-1. Data are not seasonally adjusted to permit comparison between Oct 2011 and Oct 2012. Total assets of US commercial banks grew 3.1 percent from $12,503 billion in Oct 2011 to $12,885 billion in Oct 2012. US GDP in 2011 is estimated at $15,076 billion (http://www.bea.gov/iTable/index_nipa.cfm). Thus, total assets of US commercial banks are equivalent to around 80 percent of US GDP. Bank credit grew 5.4 percent from $9356 billion in Oct 2011 to $9861 billion in Oct 2012. Securities in bank credit increased 8.3 percent from $2483 billion in Oct 2011 to $2689 billion in Oct 2012. A large part of securities in banking credit consists of US Treasury and agency securities, growing 9.5 percent from $1686 billion in Oct 2011 to $1847 billion in Oct 2012. Credit to the government that issues or backs Treasury and agency securities of $1847 in Oct 2012 is about 18.7 percent of total bank credit of US commercial banks of $9861 billion. Mortgage-backed securities, providing financing of home loans, grew 8.8 percent, from $1225 billion in Oct 2011 to $1333 billion in Oct 2012. Loans and leases were less dynamic, growing 4.4 percent from $6873 billion in Oct 2011 to $7172 billion in Oct 2012. The only dynamic class is commercial and industrial loans, growing 12.7 percent from Oct 2011 to Oct 2012 and providing $1481 billion or 20.7 percent of total loans and leases of $7172 billion in Oct 2012. Real estate loans increased only 1.1 percent, providing $3536 billion in Oct 2012 or 49.3 percent of total loans and leases. Consumer loans increased only 2.3 percent, providing $1113 billion in Oct 2012 or 15.5 percent of total loans. Cash assets “include vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks” (http://www.federalreserve.gov/releases/h8/current/default.htm). Cash assets in US commercial banks fell 6.6 percent from $1706 billion in Oct 2011 to $1594 billion in Oct 2012 but a single year of the series masks exploding cash in banks as a result of unconventional monetary policy, which is discussed below. Bank deposits increased 7.3 percent from $8372 billion to $8984 billion. The difference between bank deposits and total loans and leases in banks increased from $1499 billion in Oct 2011 to $1812 billion in Oct 2012 or by $313 billion, which is similar to the increase in securities in bank credit by $206 billion from $2483 billion in Oct 2011 to $2689 billion in Oct 2012 and to the increase in Treasury and agency securities by $160 billion from $1687 billion in Oct 2011 to $1847 billion in Oct 2012. Loans and leases increased $299 billion from $6873 billion in Oct 2011 to $7172 billion in Oct 2012. Banks expanded both lending and investment in lower risk securities partly because of the weak economy and credit disappointments during the global recession that has resulted in an environment of fewer sound lending opportunities. Lower interest rates resulting from monetary policy may not necessarily encourage higher borrowing in the current loss of dynamism of the US economy with real disposable income per capita in IIIQ2012 lower than in IVQ2007 (Table II-3) in contrast with long-term growth of per capita income in the United States at 2 percent per year from 1870 to 2010 (Lucas 2011May).

Table II-1, US, Assets and Liabilities of Commercial Banks, NSA, Billions of Dollars

	Oct 2011	Oct 2012	∆%
Total Assets	12,503	12,885	3.1
Bank Credit	9356	9861	5.4
Securities in Bank Credit	2483	2689	8.3
Treasury & Agency Securities	1686	1847	9.5
Mortgage-Backed Securities	1225	1333	8.8
Loans & Leases	6873	7172	4.4
Real Estate Loans	3498	3536	1.1
Consumer Loans	1088	1113	2.3
Commercial & Industrial Loans	1314	1481	12.7
Other Loans & Leases	973	1043	7.2
Cash Assets*	1706	1594	-6.6
Total Liabilities	11,075	11,387	2.8
Deposits	8372	8984	7.3

Note: balancing item of residual assets less liabilities not included

*”Includes vault cash, cash items in process of collection, balances due from depository institutions and balances due from Federal Reserve Banks.”

Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/h8/current/default.htm

Seasonally adjusted annual equivalent rates (SAAR) of change of selected assets and liabilities of US commercial banks from the report H.8 of the Board of Governors of the Federal Reserve System are provided in Table II-2 annually from 2007 to 2011 and for Sep and Oct 2012. The global recession had strong impact on bank assets as shown by declines of total assets of 6.0 percent in 2009 and 2.7 percent in 2010. Loans and leases fell 10.2 percent in 2009 and 5.8 percent in 2010. Commercial and industrial loans fell 18.6 percent in 2009 and 8.9 percent in 2011. Unconventional monetary policy caused an increase of cash assets of banks of 157.3 percent in 2008, 47.9 percent in 2009 and 47.4 percent in 2011 and at the SAAR of 29.8 percent in Aug 2012 but contraction by 64.9 percent in Sep 2012. Acquisitions of securities for the portfolio of the central bank injected reserves in depository institutions that were held as cash and reserves at the central banks because of the lack of sound lending opportunities and the adverse expectations in the private sector on doing business. The truly dynamic investment of banks has been in securities in bank credit, growing at the SAAR of 15.4 percent in Jul 2012, 6.7 percent in Sep 2012 and 4.7 percent in Oct 2012. Throughout the crisis banks allocated increasing part of their assets to the safety of Treasury and agency securities, or credit to the US government and government-backed credit, with growth of 15.5 percent in 2009 and 15.1 percent in 2010 and at the rate of 16.3 percent in Jul 2012, declining to the rate of 4.7 percent in Aug 2012, 2.8 percent in Sep 2012 and 0.3 percent in Oct 2012. Deposits grew at the rate of 10.5 percent in Jul 2012, with the rate declining as for most assets of commercial banks to the rate of 5.3 percent in Aug 2012 but increasing to 7.8 percent in Sep 2012 and 8.9 percent in Oct 2012. The credit intermediation function of banks is broken because of adverse expectations on future business and is not easily mended simply by monetary and fiscal policy. Incentives to business and consumers are more likely to be effective in this environment in recovering willingness to assume risk on the part of the private sector, which is the driver of growth and job creation.

Table II-2, US, Selected Assets and Liabilities of Commercial Banks, Seasonally Adjusted Annual Rate, ∆%

	2007	2008	2009	2010	2011	Sep 2012	Oct 2012
Total Assets	10.3	7.9	-6.0	-2.7	5.3	-5.3	0.3
Bank Credit	9.3	2.1	-6.6	-2.7	1.8	3.4	2.4
Securities in Bank Credit	6.2	-2.0	6.8	6.8	1.7	6.7	4.7
Treasury & Agency Securities	-6.4	3.1	15.5	15.1	2.9	2.8	0.3
Other Securities	26.8	-8.3	-5.1	-7.1	-0.8	15.5	14.7
Loans & Leases	10.2	3.3	-10.2	-5.8	1.8	2.2	1.5
Real Estate Loans	7.0	-0.2	-5.6	-5.5	-3.8	2.2	-2.7
Consumer Loans	5.4	5.1	-3.3	-6.9	-0.6	1.3	2.3
Commercial & Industrial Loans	18.1	12.9	-18.6	-8.9	9.6	1.4	13.0
Other Loans & Leases	19.2	1.7	-23.3	0.1	18.8	4.4	-0.9
Cash Assets	-0.1	157.3	47.9	-8.0	47.4	-64.9	-3.0
Total Liabilities	11.1	10.6	-7.2	-3.4	5.5	-2.4	-4.0
Deposits	9.1	5.4	5.2	2.4	6.7	7.8	8.9

Source: Board of Governors of the Federal Reserve System http://www.federalreserve.gov/releases/h8/current/default.htm

Chart II-1 of the Board of Governors of the Federal Reserve System provides quarterly seasonally adjusted annual rates (SAAR) of cash assets in US commercial banks from 1973 to 2012. Unconventional monetary policy caused an increase in cash assets in late 2008 of close to 500 percent at SAAR and also in following policy impulses. Such aggressive policies were not required for growth of GDP at the average rate of 5.7 percent in 13 quarters of cyclical expansion from IQ1983 to IV1985 while the average rate in 13 quarters of cyclical expansion from IIIQ2009 to IIIQ2012 has been at the rate of 2.2 percent (http://cmpassocregulationblog.blogspot.com/2012/10/mediocre-and-decelerating-united-states.html). The difference in magnitude of the recessions is not sufficient to explain weakness of the current cyclical expansion. Bordo (2012Sep27) and Bordo and Haubrich (2012DR) find that growth is higher after deeper contractions and contractions with financial crises. There were two consecutive contractions in the 1980s with decline of 2.2 percent in two quarters from IQ1980 to IIIQ1980 and 2.7 percent from IIIQ1981 to IVQ1982 that are almost identical to the contraction of 4.7 percent from IVQ2007 to IIQ2009 (Table IIB-3). There was also a decade-long financial and banking crisis during the 1980s. The debt crisis of 1982 (Pelaez 1986) wiped out a large part of the capital of large US money-center banks. Benston and Kaufman (1997, 139) find that there was failure of 1150 US commercial and savings banks between 1983 and 1990, or about 8 percent of the industry in 1980, which is nearly twice more than between the establishment of the Federal Deposit Insurance Corporation in 1934 through 1983. More than 900 savings and loans associations, representing 25 percent of the industry, were closed, merged or placed in conservatorships (see Pelaez and Pelaez, Regulation of Banks and Finance (2008b), 74-7). The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) created the Resolution Trust Corporation (RTC) and the Savings Association Insurance Fund (SAIF) that received $150 billion of taxpayer funds to resolve insolvent savings and loans. The GDP of the US in 1989 was $5482.1 billion (http://www.bea.gov/iTable/index_nipa.cfm), such that the partial cost to taxpayers of that bailout was around 2.7 percent of GDP in a year. US GDP in 2011 is estimated at $15,075.7 billion, such that the bailout would be equivalent to cost to taxpayers of about $412.5 billion in current GDP terms. A major difference with the Troubled Asset Relief Program (TARP) for private-sector banks is that most of the costs were recovered with interest gains whereas in the case of savings and loans there was no recovery.

Chart II-1, US, Cash Assets, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart II-2 of the Board of Governors of the Federal Reserve System provides quarterly SAARs of bank credit at US commercial banks from 1973 to 2012. Rates collapsed sharply during the global recession as during the recessions of the 1980s and then rebounded. In both episodes rates of growth of bank credit did not return to earlier magnitudes.

Chart II-2, US, Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart II-3 of the Board of Governors of the Federal Reserve System provides deposits at US commercial banks from 1973 to 2012. Deposits fell sharp during and after the global recession but then rebounded in the cyclical expansion.

Chart II-3, US, Deposits, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

There is similar behavior in the 1980s and in the current cyclical expansion of SAARs holdings of Treasury and agency securities in US commercial banks provided in Chart II-4 of the Board of Governors of the Federal Reserve System for the period 1973 to 2012. Sharp reductions of holdings during the contraction were followed by sharp increases.

Chart II-4, US, Treasury and Agency Securities in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart II-5 of the Board of Governors of the Federal Reserve System provides SAARs of change of total loans and leases in US commercial banks from 1973 to 2012. The decline in the current cycle of SAARs was much sharper and the rebound did not recover earlier growth rates. Part of the explanation originates in demand for loans that was high during rapid economic growth at 5.7 percent per year on average in the cyclical expansion of the 1980s in contrast with lower demand during tepid economic growth at 2.2 percent per year on average in the current weak expansion.

Chart II-5, US, Loans and Leases in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

There is significant difference in the two cycles of the 1980s and the current one in quarterly SAARs of real estate loans in US commercial banks provided in Chart II-6 of the Board of Governors of the Federal Reserve System. The difference is explained by the debacle in real estate after 2006 compared to expansion during the 1980s even in the midst of the crisis of savings and loans and real estate credit. In both cases, government policy tried to influence recovery and avoid market clearing.

Chart II-6, US, Real Estate Loans in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

There is significant difference in quarterly SAARs of change of consumer loans in US commercial banks in the 1980s and during the current cycle as shown in Chart II-7 of the Board of Governors of the Federal Reserve System. Quarterly SAARs of consumer loans in US commercial banks fell sharply during the contraction of 1980 and oscillated with upward trend during the contraction of 1983-1984 but increased sharply in the cyclical expansion. In contrast, SAARs of consumer loans in US commercial banks collapsed to high negative magnitudes during the contraction and have increased at very low magnitudes during the current cyclical expansion.

Chart II-7, US, Consumer Loans in Bank Credit, Commercial Banks, Seasonally Adjusted Annual Rate, Monthly, 1973-2012, ∆%

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Table II-3 provides the data required for broader comparison of the cyclical expansions of IQ1983 to IVQ1985 and the current one from 2009 to 2012. First, in the 13 quarters from IQ1983 to IVQ1985, GDP increased 19.6 percent at the annual equivalent rate of 5.7 percent; real disposable personal income (RDPI) increased 14.5 percent at the annual equivalent rate of 4.3 percent; RDPI per capita increased 11.5 percent at the annual equivalent rate of 3.4 percent; and population increased 2.7 percent at the annual equivalent rate of 0.8 percent. Second, in the 13 quarters of the current cyclical expansion from IIIQ2009 to IIIQ2012, GDP increased 7.2 percent at the annual equivalent rate of 2.2 percent. In the 12 quarters of cyclical expansion real disposable personal income (RDPI) increased 5.7 percent at the annual equivalent rate of 1.7 percent; RDPI per capita increased 3.3 percent at the annual equivalent rate of 1.0 percent; and population increased 2.3 percent at the annual equivalent rate of 0.7 percent. Third, since the beginning of the recession in IVQ2007 to IIIQ2012, GDP increased 2.2 percent, or barely above the level before the recession. Since the beginning of the recession in IVQ2007 to IIIQ2012, real disposable personal income increased 3.7 percent at the annual equivalent rate of 0.7 percent; population increased 3.9 percent at the annual equivalent rate of 0.8 percent; and real disposable personal income per capita is 0.2 percent lower than the level before the recession. Real disposable personal income is the actual take home pay after inflation and taxes and real disposable income per capita is what is left per inhabitant. The current cyclical expansion is the worst in the period after World War II in terms of growth of economic activity and income. The United States grew during its history at high rates of per capita income that made its economy the largest in the world. That dynamism is disappearing. Bordo (2012 Sep27) and Bordo and Haubrich (2012DR) provide strong evidence that recoveries have been faster after deeper recessions and recessions with financial crises, casting serious doubts on the conventional explanation of weak growth during the current expansion allegedly because of the depth of the contraction from IVQ2007 to IIQ2009 of 4.7 percent and the financial crisis.

Table II-3, US, GDP, Real Disposable Personal Income, Real Disposable Income per Capita and Population in 1983-85 and 2007-2011, %

	# Quarters	∆%	∆% Annual Equivalent
IQ1983 to IVQ1985	13
GDP		19.6	5.7
RDPI		14.5	4.3
RDPI Per Capita		11.5	3.4
Population		2.7	0.8
IIIQ2009 to IIIQ2012	13
GDP		7.2	2.2
RDPI		5.7	1.7
RDPI per Capita		3.3	1.0
Population		2.3	0.7
IVQ2007 to IIIQ2012	20
GDP		2.2	0.4
RDPI		3.7	0.7
RDPI per Capita		-0.2
Population		3.9	0.8

RDPI: Real Disposable Personal Income

Source: US Bureau of Economic Analysis http://www.bea.gov/iTable/index_nipa.cfm

Chart II-8 of the Board of Governors of the Federal Reserve System provides cash assets in commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Acquisitions of securities for the portfolio of the central bank were processed by increases in bank cash reserves. There is no comparable experience in US economic history and such flood of money was never required to return US economic growth to trend of 3 percent per year and 2 percent per year in per capita income after events such as recessions and wars (Lucas 2011May). It is difficult to argue that higher magnitudes of monetary and fiscal policy impulses would have been more successful. Selective incentives to the private sector of a long-term nature could have been more effective.

Chart II-8, US, Cash Assets in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart II-9 of the Board of Governors of the Federal Reserve System provides total assets of Federal Reserve Banks in millions of dollars on Wednesdays from 2002 to 2012. This is what is referred as the leverage of the central bank balance sheet in monetary policy (Pelaez and Pelaez, Financial Regulation after the Global Recession (2009a), 157-62, Regulation of Banks and Finance (2009b) 224-27). Consecutive rounds of unconventional monetary policy increased total assets by purchase of mortgage-backed securities, agency securities and Treasury securities. Bank reserves in cash and deposited at the central bank swelled as shown in Chart IIB-8. The central bank created assets in the form of securities financed with creation of liabilities in the form of reserves of depository institutions.

Chart II-9, US, Total Assets of Federal Reserve Banks, Wednesday Level, Millions of Dollars, 2002 to 2012

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1

Chart II-10 of the Board of Governors of the Federal Reserve System provides deposits in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Deposit growth clearly accelerated after 2001 and continued during the current cyclical expansion after bumps during the global recession.

Chart II-10, US, Deposits in Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart II-11 of the Board of Governors of the Federal Reserve System provides Treasury and agency securities in US commercial banks, not seasonally adjusted, in billions of dollars from 1973 to 2012. Holdings stabilized between the recessions of 2001 and after IVQ2007. There was rapid growth during the global contraction especially after unconventional monetary policy in 2008 and nearly vertical increase without prior similar historical experience during the various bouts of unconventional monetary policy. Banks hoard cash and less risky Treasury and agency securities instead of risky lending because of the weakness of the economy and the lack of demand for financing sound business projects.

Chart II-11, US, Treasury and Agency Securities in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart II-12 of the Board of Governors of the Federal Reserve System provides total loans and leases in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Total loans and leases of US commercial banks contracted sharply and have stalled during the cyclical expansion.

Chart II-12, US, Loans and Leases in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart II-13 of the Board of Governors of the Federal Reserve System provides real estate loans in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Housing subsidies and low interest rates caused a point of inflexion to higher, nearly vertical growth until 2007. Real estate loans have contracted in downward trend partly because of adverse effects of uncertainty on the impact on balance sheets of the various mechanisms of resolution imposed by policy.

Chart II-13, US, Real Estate Loans in Bank Credit, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Chart II-14 of the Board of Governors of the Federal Reserve System provides consumer loans in US commercial banks not seasonally adjusted in billions of dollars from 1973 to 2012. Consumer loans even increased during the contraction then declined and increased vertically to decline again. There was high demand for reposition of durable goods that exhausted and limited consumption again with increase in savings rates in recent periods.

Chart II-14, US, Consumer Loans in Bank Credit, Not Seasonally Adjusted, US Commercial Banks, Monthly, 1973-2012, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

Finally, Chart II-15 of the Board of Governors of the Federal Reserve System provides commercial and industrial loans not seasonally adjusted in billions of dollars from 1973 to 2012. Commercial and industrial loans fell sharply during both contractions in 2001 and after IVQ2007 and then rebounded with accelerated growth. Commercial and industrial loans have not reached again the peak during the global recession.

Chart II-15, US, Commercial and Industrial Loans in Bank Credit, US Commercial Banks, Not Seasonally Adjusted, Monthly, 1973-2012, Billions of Dollars

Source: Board of Governors of the Federal Reserve System

http://www.federalreserve.gov/releases/h8/current/default.htm

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Sunday, November 25, 2012

Contraction of United States Real Private Fixed Investment with Swelling Undistributed Corporate Profits, Higher Growth of Deposits, Securities and Cash Assets than Loans in United States Commercial Banks and World Financial Turbulence and Economic Slowdown with Global Recession Risk: Part I

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